A theoretical model of imperfect markets and investment

Empirical evidence suggests that market imperfections affect firm investment choices, while the theoretical mechanisms underlying such findings are still unexplored. This paper attempts to model the contemporaneous impact of financial and labor market imperfections on investment. A neoclassical investment model with costly external finance is augmented by adjustment costs of investment affected by the level of labor market regulation. Results show that the impact of labor market regulation and its interaction with financial market imperfections on investment depends on the tightness prevailing in the firm production environment. Labor market regulation has a larger effect on investment in the presence of more efficient financial markets. Findings suggest that as long as the firm is operating below its potential output, an increase in labor regulation might stimulate the need for firms to substitute labor with capital investment, and this impact is greater the higher the efficiency in the financial market