INTRODUCTION Consider, once more, our most simple model of the ﬁrm (see Part 1). In this model, ﬁrms maximize proﬁts by employing production factors from an unbounded set. By positing that choice-sets are unconstrained, however, this model implicitly assumes that production factors costlessly move to their highest valued use, and thus abstracts from the potential for ﬁnancial markets to inﬂuence economic performance. Just as we saw in Part II that goods and services do not costlessly move to their highest valued use (that is, bartering is costly), we’ll see in the present chapter that ﬁnancial capital does not costlessly move to its highest valued use. Indeed, just as bartering deters even mutually beneﬁcial trades by creating frictions in goods markets, asymmetric information discourages such trades by introducing frictions to ﬁnancial markets. Likewise, just as money can enhance economic welfare by mitigating costs associated with bartering, ﬁnancial intermediation and corporate governance can enhance welfare by mitigating costs associated with asymmetric information. A slightly richer model of the ﬁrm will help us develop this insight. Suppose that, instead of choosing from an unbounded set of factors, ﬁrms face a ‘cash constraint’ where limited internal resources preclude the hiring of factors that would maximize proﬁts. In Figure 13.1, for example, the ﬁrm’s current assets might limit the employment of inputs to X , even though hiring inputs up to X* would increase proﬁts. Even a cash-constrained ﬁrm can be a maximizer, however. Consequently, if it could expand production (and...
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