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

  • Bert Willems
  • Joris Morbee

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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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
Contact details of provider: Postal: Convento, Via delle Fontanelle, 19, 50014 San Domenico di Fiesole (FI) Italy
Web page: http://www.eui.eu/RSCAS/

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  1. 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.
  2. 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.
  3. Perrakis, Stylianos & Warskett, George, 1983. "Capacity and Entry under Demand Uncertainty," Review of Economic Studies, Wiley Blackwell, vol. 50(3), pages 495-511, July.
  4. Eric S. Maskin, 1999. "Uncertainty and entry deterrence," Economic Theory, Springer, vol. 14(2), pages 429-437.
  5. Dixit, Avinash, 1979. "The Role of Investment in Entry-Deterrence," The Warwick Economics Research Paper Series (TWERPS) 140, University of Warwick, Department of Economics.
  6. Franco Modigliani, 1958. "New Developments on the Oligopoly Front," Journal of Political Economy, University of Chicago Press, vol. 66, pages 215.
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