Favouritism or Markets in Capital Allocation?

Mariassunta Giannetti and Xiaoyun Yu

No 6124, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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: Finance and growth; Information production; Competition for capital; Exchange competition (search for similar items in EconPapers)
JEL-codes: G1 G3 (search for similar items in EconPapers)
Date: 2007-02
New Economics Papers: this item is included in nep-cfn and nep-ent
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