On limited liability and the development of capital markets: An historical analysis
AbstractWe study the consequences of the introduction of widespread limited liability for corporations, with particular reference to the liability reforms introduced in Great Britain during the nineteenth century. In the view that is most widely accepted, by reducing transactions costs associated with screening and monitoring in capital markets, limited liability increases efficiency of capital markets and enhances investment incentives for individuals and firms. But the standard transaction-cost perspective does not explain several important stylized facts of the British experience. We construct an alternative model of asymmetric information and default in credit markets that accounts for this and other features of the British experience. In the model, a firm's decision to adopt limited liability may be interpreted in equilibrium as a signal the firm is more likely to default. Hence less risky firms may choose unlimited liability or forego investments entirely. We show the model may have multiple, Pareto-rankable equilibria in which different proportions of the firms choose to incorporate with limited liability and different levels of aggregate investment result. Thus the choice of liability rule can lead to ``development traps,'' in which profitable investments are not undertaken, through its effect on equilibrium beliefs of uninformed investors in the economy. We apply the theory to a data set describing the first English firms to incorporate after the legislative reforms of 1856.
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Bibliographic InfoPaper provided by University of Toronto, Department of Economics in its series Working Papers with number msmart-96-02.
Length: 25 pages
Date of creation: 27 Jun 1996
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Find related papers by JEL classification:
- K2 - Law and Economics - - Regulation and Business Law
- N2 - Economic History - - Financial Markets and Institutions
- G3 - Financial Economics - - Corporate Finance and Governance
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