On Limited Liability and the Development of Capital Markets: An Historical Analysis

25 Pages Posted: 9 Dec 1996

See all articles by Michael Smart

Michael Smart

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

Date Written: June 1996

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, including the slow rate of adoption of limited liability by firms in the years following legal reforms. 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.

JEL Classification: G35, K33, N23

Suggested Citation

Smart, Michael, On Limited Liability and the Development of Capital Markets: An Historical Analysis (June 1996). Available at SSRN: https://ssrn.com/abstract=1175 or http://dx.doi.org/10.2139/ssrn.1175

Michael Smart (Contact Author)

University of Toronto - Department of Economics ( email )

150 St. George Street
Institute for Policy Analysis
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Canada
416-978-5119 (Phone)
416-978-6713 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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