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Risk Spillovers and Hedging: Why Do Firms Invest Too Much in Systemic Risk?

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  • Bert Willems
  • Joris Morbee

Abstract

In this paper we show that free entry decisions may be socially ineffcient, even in a perfectly competitive homogeneous goods market with non-lumpy investments. In our model, inefficient entry decisions are the result of risk-aversion of incumbent producers and consumers, combined with incomplete financial markets which limit risk-sharing between market actors. Investments in productive assets affect the distribution of equilibrium prices and quantities, and create risk spillovers. From a societal perspective, entrants underinvest in technologies that would reduce systemic sector risk, and may overinvest in risk-increasing technologies. The inefficiency is shown to disappear when a complete financial market of tradable risk-sharing instruments is available, although the introduction of any individual tradable instrument may actually decrease effciency.

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File URL: http://cadmus.eui.eu/bitstream/handle/1814/22778/RSCAS_2012_35.pdf?sequence=1
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File URL: http://hdl.handle.net/1814/22778
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Bibliographic Info

Paper provided by European University Institute in its series RSCAS Working Papers with number 2012/35.

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Date of creation: 05 Jun 2012
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Handle: RePEc:rsc:rsceui:2012/35

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  1. Dixit, Avinash, 1980. "The Role of Investment in Entry-Deterrence," Economic Journal, Royal Economic Society, vol. 90(357), pages 95-106, March.
  2. Schmalensee, Richard, 1981. "Economies of Scale and Barriers to Entry," Journal of Political Economy, University of Chicago Press, vol. 89(6), pages 1228-38, December.
  3. Eric S. Maskin, 1999. "Uncertainty and entry deterrence," Economic Theory, Springer, vol. 14(2), pages 429-437.
  4. Perrakis, Stylianos & Warskett, George, 1983. "Capacity and Entry under Demand Uncertainty," Review of Economic Studies, Wiley Blackwell, vol. 50(3), pages 495-511, July.
  5. Franco Modigliani, 1958. "New Developments on the Oligopoly Front," Journal of Political Economy, University of Chicago Press, vol. 66, pages 215.
  6. Hugonnier, Julien & Morellec, Erwan, 2007. "Corporate control and real investment in incomplete markets," Journal of Economic Dynamics and Control, Elsevier, vol. 31(5), pages 1781-1800, May.
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