Scandinavian Working Papers in Economics

SIFR Research Report Series,
Institute for Financial Research

No 50: Favoritism or Markets in Capital Allocation?

Mariassunta Giannetti () and Xiaoyun Yu ()
Additional contact information
Mariassunta Giannetti: Stockholm School of Economics, Postal: Department of Finance, P O Box 6501, 113 83 Stockholm, Sweden
Xiaoyun Yu: Kelley School of Business, Postal: Indiana University

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 firms.

Keywords: Finance and growth; information production; competition for capital; exchange competition

JEL-codes: G10; G30

45 pages, March 15, 2007

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