Risk spillovers and hedging: why do firms invest too much in systemic risk?
In this paper we show that free entry decisions may be socially inefficient, 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 efficiency. We therefore believe that sectors without well-developed financial markets will benefit from sector-specific regulation of investment decisions.
|Date of creation:||May 2011|
|Contact details of provider:|| Web page: http://feb.kuleuven.be/Economics/|
References listed on IDEAS
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- Schmalensee, Richard, 1981.
"Economies of Scale and Barriers to Entry,"
Journal of Political Economy,
University of Chicago Press, vol. 89(6), pages 1228-1238, December.
- Schmalensee, Richard., 1980. "Economies of scale and barriers to entry," Working papers 1130-80., Massachusetts Institute of Technology (MIT), Sloan School of Management.
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- Willems, Bert & Morbee, Joris, 2010. "Market completeness: How options affect hedging and investments in the electricity sector," Energy Economics, Elsevier, vol. 32(4), pages 786-795, July.
- Stylianos Perrakis & George Warskett, 1983. "Capacity and Entry Under Demand Uncertainty," Review of Economic Studies, Oxford University Press, vol. 50(3), pages 495-511. Full references (including those not matched with items on IDEAS)
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