Dynamic inefficiency in decentralized capital markets

We study the effi ciency implications of bargaining in frictional capital markets in which firms match bilaterally with dealers in order to buy or sell capital. We show how two of the distinguishing characteristics of capital —ownership and the intertemporal nature of investment —give rise to a dynamic ineffi ciency. Firms that anticipate buying capital in the future overinvest because this increases their outside option of no trade in negotiations with dealers in the future, thereby lowering the bargained purchase price. Vice versa, firms that anticipate selling capital in the future strategically underinvest because this increases the bargained sale price. If the only motive for trade is capital depreciation, there is overinvestment in capital. With stochastic productivity, there is insuffi cient dispersion of capital across firms and investment is insuffi ciently responsive to shocks. A regressive tax on capital can restore the effi cient capital allocation. ∗We thank Jun Ishii, Ricardo Lagos, Miguel Leon-Ledesma, Guillaume Rocheteau, and participants at the Federal Reserve Board’s brown bag seminar, the Search and Matching Workshop at the Federal Reserve Bank of Philadelphia, the 2013 meetings of the Canadian Economic Association, the 2013 China meeting of the Econometric Society, the 2013 Summer Workshop on Money, Banking, Payments and Finance at the Federal Reserve Bank of Chicago, and the 2013 European meeting of the Econometric Society for helpful comments and discussions. †Contact: [email protected] ‡Contact: [email protected]