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Dynamic Inefficiency in Decentralized Capital Markets

Author

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  • Kurmann, André

    () (School of Economics)

  • Rabinovich, Stanislav

    () (Department of Economics Amherst College)

Abstract

We study the efficiency implications of bargaining in frictional capital markets in which firms match bilaterally with dealers in order to buy or sell capital. We show how two of the distinguishing characteristics of capital – ownership and the intertemporal nature of investment – give rise to a dynamic inefficiency. Firms that anticipate buying capital in the future overinvest because this increases their outside option of no trade in negotiations with dealers in the future, thereby lowering the bargained purchase price. Vice versa, firms that anticipate selling capital in the future strategically underinvest because this increases the bargained sale price. If the only motive for trade is capital depreciation, there is overinvestment in capital. With stochastic productivity, there is insufficient dispersion of capital across firms and investment is insufficiently responsive to shocks. A regressive tax on capital can restore the efficient capital allocation.

Suggested Citation

  • Kurmann, André & Rabinovich, Stanislav, 2016. "Dynamic Inefficiency in Decentralized Capital Markets," School of Economics Working Paper Series 2016-1, LeBow College of Business, Drexel University.
  • Handle: RePEc:ris:drxlwp:2016_001
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    Keywords

    Dynamic inefficiency; trading frictions; bargaining; over-the-counter markets.;

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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