Working Paper: CEPR ID: DP6124
Authors: Mariassunta Giannetti; Xiaoyun Yu
Abstract: Casual observation suggests that capital allocation is often driven by favouritism and connections rather than by market mechanisms and information on future expected returns. We investigate when favouritism 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 (favouritism). If the pool of saving is relatively small, favouritism 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, favouritism 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 favouritism, 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: competition for capital; exchange competition; finance and growth; information production
JEL Codes: G1; G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lack of information acquisition (D83) | Inefficient investment decisions (G11) |
| Economy development and increasing pool of savings (O16) | Need for information production (D83) |
| Accumulation of capital (E22) | Decrease in returns from familiar investments (G11) |
| Decrease in returns from familiar investments (G11) | Financiers seek distant opportunities (F39) |
| Favoritism (J15) | High rents enjoyed by entrepreneurs (R21) |
| High rents enjoyed by entrepreneurs (R21) | Discouragement of high-quality entrepreneurs from seeking markets with higher disclosure standards (L15) |
| Information acquisition (D83) | Reduction of rents for high-productivity entrepreneurs (R38) |
| Information acquisition (D83) | Increase in overall investment efficiency (G31) |