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.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Rafael La Porta & Florencio Lopez-de-Silane & Guillermo Zamarripa, 2002.
"Related Lending,"
NBER Working Papers
8848, National Bureau of Economic Research, Inc.
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Rafael La Porta & Florencio López-de-Silanes & Guillermo Zamarripa, 2003.
"Related Lending,"
The Quarterly Journal of Economics,
MIT Press, vol. 118(1), pages 231-268, February.
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