Limited Liability and the Development of Capital Markets

33 Pages Posted: 19 Oct 2007

See all articles by Ed Nosal

Ed Nosal

Federal Reserve Banks - Federal Reserve Bank of Atlanta

Michael Smart

University of Toronto - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: March 2007

Abstract

We study the consequences of the introduction of widespread limited liability for corporations. In the traditional view, limited liability reduces transactions costs and enhances investment incentives for individuals and firms. But this view does not explain several important stylized facts of the British experience, including the slow rate of adoption of limited liability by firms in the years following legal reforms. We construct an alternative model that accounts for this and other features of the nineteenth century British experience. In the model, project risk is private information, and 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 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.

Keywords: limited liability, capital markets, risk, investment

JEL Classification: D24, D92

Suggested Citation

Nosal, Ed and Smart, Michael, Limited Liability and the Development of Capital Markets (March 2007). FRB of Cleveland Working Paper No. 07-03. Available at SSRN: https://ssrn.com/abstract=1022052 or http://dx.doi.org/10.2139/ssrn.1022052

Ed Nosal (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

Michael Smart

University of Toronto - Department of Economics ( email )

150 St. George Street
Institute for Policy Analysis
Toronto, Ontario M5S 3G7
Canada
416-978-5119 (Phone)
416-978-6713 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

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Munich, DE-81679
Germany

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