How Costly Are Limited Liability Rules?

We quantify the cost of limited liability rules in a traditional model of investment financing under moral hazard and risk aversion. Under limited liability, we show that external debt and the granting of absolute priority to debtholders are key (but not the unique) ingredients of the optimal financing package. Removing liability limits makes possible a superior contract that punishes the entrepreneur harshly for bad performance. We interpret these harsh penalties in terms of debtors’ prisons, and quantify the deadweight losses brought about by the judicial imposition of liability limits. For reasonable parametrizations, the losses are significant. Our results indicate that the costs associated with unlimited liability and debtors' prisons must be substantial to explain the ubiquity of limited liability rules in modern economies. JEL-Classification: G32, D82