Capital accumulation under different financial agreements (Q1175373)

This paper investigates the effects of incomplete markets on productive investment in a simple one good, three periods overlapping generations model. Although the title refers to `capital accumulation', growth phenomena are not studied. The size of the capital stock reflects the size of endowments received by agents in the second period, eventually their random variations. Starting from the fundamental proposition that a deterministic path of capital stock levels is strictly superior to a path subject to random shocks in endowments, two institutional setups are compared. Whereas in the first regime realizations of the (random) endowment variable are known to all agents, this information must be extracted at a cost by non- recipients of endowments in the second. Consequently, only in the first regime complete markets for contingent claims unfold while in the second only standard loan contracts at predetermined interest rates are available. It is then shown that, with complete markets, returns on all assets equalize and are independent of the random shocks. The economy effectively mimics the behaviour of the deterministic reference case and eliminates inefficiency through optimal markets. This result cannot be sustained for the second regime where monitoring costs are positive and decreasing with the number of agents monitored. Thus costs can be minimized through financial intermediation. It is then established that in this case the level of the stock of capital depends crucially on the realization of the stochastic variable. Insurance against income fluctuations is impossible, the expected level of capital is strictly smaller than in the first regime and the economy suffers an efficiency loss.