Product Market Efficiency: The Bright Side of Myopic, Uninformed, and Passive External Finance
68 Pages Posted: 25 Feb 2008 Last revised: 20 Mar 2010
Date Written: March 1, 2010
Short-term financial claims held by uninformed outside investors impose a tax on insider opportunism by diluting the ownership stake of opportunistic owner-managers. By thus limiting managerial opportunism, short-term financing increases firm value and social welfare. When given a choice, owner-managers will prefer socially beneficial short-term external financing over internal financing. We show that these results are equilibrium outcomes of a model where firms can act opportunistically in product markets. Moreover, we document the same beneficial effect of short-term external finance in a laboratory experiment implementing this game.
Keywords: Adverse selection, financing, reputation
JEL Classification: C91, D82, G31, G32, L15
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