Abstract - Relationships and Information Acquisition in Capital Allocation

This paper explores to what extent, depending on the level of development, quality of institutions and investment opportunities, financiers allocate capital on the basis of prior relationships, instead of collecting information on the productivity of several potential entrepreneurs. We show that when information is unreliable and costly, relationship-based financing prevails. Nevertheless, if the pool of saving is relatively small, only high productivity entrepreneurs receive funding. As the economy develops and the pool of saving increases, information production becomes crucial for preventing the funding of low productivity entrepreneurs. However, financiers may find it optimal to fund entrepreneurs they are familiar with even if these have low productivity. Since competition for capital is low if financing is relationship-driven, 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. 

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