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Favoritism or Markets in Capital Allocation?

Author

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  • Giannetti, Mariassunta

    () (Stockholm School of Economics)

  • Yu, Xiaoyun

    () (Kelley School of Business)

Abstract

Casual observation suggests that capital allocation is often driven by favoritism and connections rather than by market mechanisms and information on future expected returns. We investigate when favoritism 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 (favoritism). If the pool of saving is relatively small, favoritism 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, favoritism 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 favoritism, 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.

Suggested Citation

  • Giannetti, Mariassunta & Yu, Xiaoyun, 2007. "Favoritism or Markets in Capital Allocation?," SIFR Research Report Series 50, Institute for Financial Research.
  • Handle: RePEc:hhs:sifrwp:0050
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    Cited by:

    1. Benjamin E. Hermalin & Michael S. Weisbach, 2012. "Information Disclosure and Corporate Governance," Journal of Finance, American Finance Association, vol. 67(1), pages 195-234, February.
    2. Ulf Axelson & Sandeep Baliga, 2009. "Liquidity and Manipulation of Executive Compensation Schemes," Review of Financial Studies, Society for Financial Studies, vol. 22(10), pages 3907-3939, October.
    3. Rydqvist, Kristian, 2010. "Tax Arbitrage with Risk and Effort Aversion - Swedish Lottery Bonds 1970-1990," SIFR Research Report Series 70, Institute for Financial Research.
    4. Fedyk, Yuriy & Walden, Johan, 2007. "High-Speed Natural Selection in Financial Markets with Large State Spaces," SIFR Research Report Series 52, Institute for Financial Research.
    5. Bekaert, Geert & Harvey, Campbell R. & Lundblad, Christian, 2011. "Financial Openness and Productivity," World Development, Elsevier, vol. 39(1), pages 1-19, January.
    6. Dreber, Anna & Rand, David G. & Garcia, Justin R. & Wernerfelt, Nils & Lum, J. Koji & Zeckhauser, Richard, 2010. "Dopamine and Risk Preferences in Different Domains," Working Paper Series rwp10-012, Harvard University, John F. Kennedy School of Government.

    More about this item

    Keywords

    Finance and growth; information production; competition for capital; exchange competition;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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