On financial frictions and firm market power Banco de Espana

We build a static general-equilibrium model with monopolistically competitive firms that
borrow funds from competitive banks in an economy subject to financial frictions. These
frictions are due to non verifiability of both ex post fi rm returns and managerial effort. Market
power has opposing effects. On one side, firms’ pricing over marginal cost reduces output
compared to perfect competition. On the other, by increasing firms’ profitability, market
power reduces the impact of financial frictions. The resulting tradeoff is ambiguous. We
show that, other things equal, there exists an optimal positive level of market power that
maximizes welfare. Such optimal degree of market power increases with moral hazard and
decreases with the efficiency of fi rm liquidation following bankruptcy