Shrinking Boundary of the Invisible Hand
67 Pages Posted: 19 Feb 2021
Date Written: December 18, 2020
Since the 1980s, capital allocation efficiency has been deteriorating in the United States. This paper argues that the rise of (superstar) firms and their cash hoarding behavior are reasons. I introduce entrepreneur-manager assignment and corporate risk management into a standard continuous-time heterogeneous agent model with incomplete markets. In this way, Coase (1937)'s firm-(financial) market boundary exists in general equilibrium, and the price mechanism is bounded by corporate internal financing as there is no market to equalize the marginal value of internal resources across firms. Therefore, contrary to conventional wisdom, self-financing (through safe assets) increases misallocation. The scale-related technical change in the 1980s increases the earnings-quality gradient sharply in the right tail, which not only generates a winners-take-most phenomenon but also makes current winners inherently riskier and rely less on external financing. This risk redistribution nature of technical change expands the internal financing region and impairs the capital allocation efficiency. When taken to the data, the model can quantitatively match some important macro-finance trends, and it shows that the area disciplined by the market system has declined about 11.2% during the past forty years.
Keywords: factor scalability; firm-market boundary; misallocation; superstar firms; risk redistribution
JEL Classification: D21; D25; D33; E14; E44; G30; L20; O33
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