Credit Constraints and Contract Enforcement

Abstract

This paper demonstrates that credit constraints can lead to the inability to enforce contracts, thereby creating inefficiency. If time elapses between the contract period and the enforcement period, a credit constrained agent that uses the proceeds of trade to fund consumption faces a greater cost to enforce a contract than an unconstrained agent. This allows the other party to a contract to hold up the credit constrained agent, thereby creating inefficiency. This is demonstrated for two types of enforcement mechanisms; enforcement of a one-time trade via the courts, and enforcement of a long-term trade via a punishment strategy.