Connections and Information Acquisition in Capital Allocation

Abstract:     
We investigate to what extent, depending on the level of initial capital, financiers allocate capital on the basis of prior connections, instead of collecting information on the productivity of a potential entrepreneur. We explore the effects of information acquisition (or the lack thereof) on investment efficiency, financiers' returns and entrepreneurial rents and show that there may be either under-investment or over-investment in information acquisition. Our results have implications for the desirability of informal finance and connected lending.

Number of Pages in PDF File: 44

Keywords: Finance and growth, Information acquisition, Competition for capital, Connection-based vs.arm's length financial systems

JEL Classification: G3, O16

working papers series