Product Market Efficiency : The Bright Side of Myopic, Uninformed, and Passive External Finance

Short-term financial claims held by uninformed outside investors impose a tax on insider opportunism by diluting the ownership stake of opportunistic owner-managers. By thus limiting managerial opportunism, short-term financing increases firm value and social welfare. When given a choice, owner-managers will prefer socially beneficial short-term external financing over internal financing. We show that these results are equilibrium outcomes of a model where firms can act opportunistically in product markets. Moreover, we document the same beneficial effect of short-term external finance in a laboratory experiment implementing this game