SIFR Research Report Series, Institute for Financial Research
Favoritism or Markets in Capital Allocation?
() and Xiaoyun Yu
Abstract: Casual observation suggests that capital allocation is
often driven by favoritism and connections rather than by market mechanisms
and information on future expected returns. We investigate when favoritism
or markets emerge as an equilibrium outcome in the allocation of capital.
We show that when information is unreliable and costly, financiers do not
have incentives to investigate distant investment opportunities and
allocate capital to entrepreneurs they are familiar with (favoritism). If
the pool of saving is relatively small, favoritism can lead to an efficient
allocation of investment. As the economy develops and its pool of saving
increases, information production and the identification of distant
investment opportunities (markets) become crucial for efficient investment
decisions. Nevertheless, favoritism may emerge in equilibrium and investors
may find it optimal to fund low quality entrepreneurs if they are familiar
with them. Since competition for capital is low in an equilibrium with
favoritism, entrepreneurs enjoy high rents. Thus, even high quality
entrepreneurs may have no incentive to join markets with standards that
foster information acquisition, but rather run inefficiently small
Keywords: Finance and growth; information production; competition for capital; exchange competition; (follow links to similar papers)
JEL-Codes: G10; G30; (follow links to similar papers)
45 pages, March 15, 2007
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