ON FINANCIAL FRICTIONS AND FIRM MARKET POWER

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 firm 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 firm liquidation following
bankruptcy