Debt- and Equity-Financed Investment: Equilibrium Structure and Efficiency Implications

This paper considers the financing of investment in the presence of information asymmetry between "insiders" and "outsiders" of the firms. It establishes a well-defined capital structure for the economy as a whole with the following features: low-productivity firms rely on the equity market to finance investment at a relatively low level; medium-productivity firms may not invest at all; and high-productivity firms rely on the debt market to finance investment at a relatively high level. It is shown that the debt market is efficient, with respect to the scope and the amount of investmentmade by each firm. However, the equity market fails: its scope is too narrow and the amount of investment each firm makes is too little. A unique but rather unconventional policy tool is proposed to achieve constrained Pareto-efficiency, i.e., subsidies to those firms that choose to equity-finance their investment (i.e., equity-market-contingent grants).