The Effect of External Finance and Internal Capital Markets on the Equilibrium Allocation of Capital

Abstract

We model the equilibrium allocation of capital in the presence of imperfect institutional development. In our model, imperfect institutional development reduces external market activity by limiting capital flows among firms, thus compromising the efficiency of economy wide capital allocation. We show that the efficiency of capital allocation increases with firms’ external financing requirements because higher external financing requirements lead to more liquidation of projects and a more active external capital market. Furthermore, a higher degree of conglomeration reduces external market activity because conglomerates allocate capital internally rather than supply it to the market. Thus, the efficiency of capital allocation may decrease in the presence of conglomerates, even when they allocate capital internally to their most productive units. Our results help explain why countries that rely heavily on external finance also have high productivity and growth, and they provide a new perspective on the recent debate about the desirability of dismantling business groups in developing countries. The fact that the main results of the paper run against the intuition obtained from partial equilibrium models shows the importance of modeling financial imperfections in an equilibrium framework in order to derive implications about overall economic efficiency.