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On limited liability and the development of capital markets: An historical analysis

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  • Michael Smart

Abstract

We 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.

Suggested Citation

  • Michael Smart, 1996. "On limited liability and the development of capital markets: An historical analysis," Working Papers msmart-96-02, University of Toronto, Department of Economics.
  • Handle: RePEc:tor:tecipa:msmart-96-02
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    References listed on IDEAS

    as
    1. Carr, Jack L & Mathewson, G Frank, 1988. "Unlimited Liability as a Barrier to Entry," Journal of Political Economy, University of Chicago Press, vol. 96(4), pages 766-784, August.
    2. Milgrom, Paul & Roberts, John, 1994. "Comparing Equilibria," American Economic Review, American Economic Association, vol. 84(3), pages 441-459, June.
    3. Forbes, Kevin F, 1986. "Limited Liability and the Development of the Business Corporation," Journal of Law, Economics, and Organization, Oxford University Press, vol. 2(1), pages 163-177, Spring.
    4. Stiglitz, Joseph E, 1969. "A Re-Examination of the Modigliani-Miller Theorem," American Economic Review, American Economic Association, vol. 59(5), pages 784-793, December.
    5. Hellwig, Martin F, 1981. "Bankruptcy, Limited Liability, and the Modigliani-Miller Theorem," American Economic Review, American Economic Association, vol. 71(1), pages 155-170, March.
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    Cited by:

    1. Paolo Maggioni, 2011. "The introduction of limited liability in nineteenth century England," Openloc Working Papers 1116, Public policies and local development.

    More about this item

    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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