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Too much investment: a problem of coordination failure

By David De Meza and Ben Lockwood

Abstract

This paper shows that coordination failure and contractual incompleteness can lead to socially excessive investment. Firms and workers choose investment levels then enter a stochastic matching process. If investment levels are discrete, then if match frictions are low enough, high investing workers (firms) impose a negative pecuniary externality on any worker (firm) who cuts investment, even by one unit. Specifically, if a worker cuts investment, he subsequently bargains with a firm which has a high outside option due to the fact it can easily match with another high investing worker; this lowers the private net benefit to cutting investment below the social net benefit. A similar argument establishes that over-investment can occur when agents are heterogenous i.e. differ in their cost of investing, even if investments are continuous. Then, over-investment occurs because low-cost investors have a private incentive to invest to shift rent away from high-cost investors. Our model can also explain some recent trends in graduate/non-graduate wage differentials

Topics: HD28, QA
Publisher: University of Warwick, Department of Economics
Year: 2004
OAI identifier: oai:wrap.warwick.ac.uk:1485

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