HKUST IEMS Working Papers No. 2015-02
This paper presents theory and evidence that tighter credit constrains force firms to produce lower quality. The paper develops a quality sorting model that predicts that tighter credit constraints faced by a firm reduce its optimal prices due to its choice of lower-quality products. Conversely, when quality cannot be chosen by a firm in an efficiency sorting model, prices increase as firms face tighter credit constraints. An empirical analysis using Chinese bank loans data and a merged sample based on Chinese firm-level data and Chinese customs data strongly supports quality sorting and confirms the mechanism of quality adjustment.
* Published as of May 2015, Journal of Comparative Economics, Vol 43(2), pp. 390-416
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