Favoritism and Markets in Capital Allocation

EFA 2007 Ljubljana Meetings Paper

47 Pages Posted: 26 Feb 2007

See all articles by Mariassunta Giannetti

Mariassunta Giannetti

Stockholm School of Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); Swedish House of Finance

Xiaoyun Yu

Indiana University - Kelley School of Business - Department of Finance; China Academy of Financial Research (CAFR)

Date Written: January 2007

Abstract

Casual observation suggests that capital allocation is often driven by favoritism and connections rather than by market mechanisms and information on future expected returns. We investigate when favoritism or markets emerge as an equilibrium outcome in the allocation of capital. We show that when information is unreliable and costly, financiers do not have incentives to investigate distant investment opportunities and allocate capital to entrepreneurs they are familiar with (favoritism). If the pool of saving is relatively small, favoritism can lead to an efficient allocation of investment. As the economy develops and its pool of saving increases, information production and the identification of distant investment opportunities (markets) become crucial for efficient investment decisions. Nevertheless, favoritism may emerge in equilibrium and investors may find it optimal to fund low quality entrepreneurs if they are familiar with them. Since competition for capital is low in an equilibrium with favoritism, entrepreneurs enjoy high rents. Thus, even high quality entrepreneurs may have no incentive to join markets with standards that foster information acquisition, but rather run inefficiently small firms.

Keywords: Finance and growth, Information production, Competition for capital, Exchange competition

JEL Classification: G1, G3

Suggested Citation

Giannetti, Mariassunta and Yu, Xiaoyun, Favoritism and Markets in Capital Allocation (January 2007). EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=965525 or http://dx.doi.org/10.2139/ssrn.965525

Mariassunta Giannetti (Contact Author)

Stockholm School of Economics ( email )

P.O. Box 6501
Sveavagen 65
SE-113 83 Stockholm
Sweden
+46 8 736 9607 (Phone)
+46 8 312 327 (Fax)

HOME PAGE: http://sites.google.com/site/mariassuntagiannetti/Home

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

Xiaoyun Yu

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States
812-855-3521 (Phone)
812-855-5875 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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