Many economic problems can be formulated as dynamic games in which strategically interacting agents choose actions that determine the current and future levels of a single capital stock. Consider, for example, a single stock of an exhaustible or reproductive resource that is simultaneously exploited by several agents that do not cooperate. Each agent chooses an extraction strategy to maximise the discounted stream of future utility.
The actions taken by agents not only determine their levels of utility but also the level of the capital stock. Alternatively, look at the problem that agents voluntarily contribute to a single public stock of capital, like a park or a church. They choose their contributions (investments in the public stock of capital) to maximise the discounted stream of utility from consuming the public stock net of investment costs. Private investment builds up the public stock of capital that eventually can be consumed by all agents.
In this paper, we examine international cost of equity capital differences across 40 countries. Recent research suggests that countries’ legal institutions are a key determinant of financial market development, capital and ownership structures, dividend policies, and firms’ equity valuations (e.g., La Porta et al, 1997, 2000a and 2002). Based on this evidence, we investigate whether the effectiveness of a country’s legal institutions has a systematic influence on its firms’ cost of equity capital, over and above traditional risk and country factors.
Well-functioning legal systems protect investors; they confer rights on investors, e.g., to receive information, and enforce financial contracts. As a result, effective legal institutions reduce monitoring and enforcement costs to investors, which may in turn reduce the expected rate of return that investors demand for their capital. Prior studies suggest that effective legal institutions increase firms’ equity valuations (e.g., La Porta et al., 2002). However, these results may reflect the effects of legal systems on firms’ cash flows, for instance, by reducing expropriation or expanding growth opportunities, rather than the effects on the risk premium demanded by investors. Thus, it is still an open question whether the quality of legal institutions manifests in systematic differences in firms’ cost of capital. Moreover, as capital markets around the world become more integrated, country specific factors may lose their importance for firms’ cost of capital (e.g., Harvey, 1991; Bekaert and Harvey, 1995). To explore these issues and to shed some light on the mechanism through which legal institutions affect valuations, we examine whether differences in countries’ securities regulation, i.e., disclosure rules and enforcement, explain international differences in cost of capital.
Why do wages differ across identical workers? Why do firm characteristics matter? What is the source of the wage dispersion that firm and worker characteristics cannot explain? To address these basic three questions, we construct and estimate an equilibrium model of the labor market with worker and firm heterogeneous match productivities and on the job search. Search frictions are indeed a cause of market imperfection which in theory resolves the three questions altogether: Wages differ across firms because search frictions are a source of inefficiency allowing less efficient firms to survive. Search frictions leave market power to employers whereby more efficient firms extract higher rents. On the job search forces employers to grant their employees wage raises randomly over time so that wages differ across identical employer employee pairs.
In our model, unemployed workers search for a job and employees search for a better job. Workers differ in ability and firms differ in the marginal productivity of efficient labor. Workers and firms are imperfectly informed about the location of worker and firm types, which precludes optimal assignments as in standard marriage models. Yet, when two agents meet, both are immediately informed about each others types. Employers have all the bargaining power and offer unemployed workers their reservation wage. The equilibrium nonetheless differs from Diamonds monopsony model as search on the job allows employees to locate alternative employers, whom they can bring into Bertrand price competition with their current employer. This competition either results in a wage rise or in job mobility, the poaching employer paying the worker a wage which can even be less than his/her current wage if the option value of turning down the best offer that the current employer can make the marginal productivity6, in exchange of a greater potential best offer the marginal productivity at the new job is large enough. Our model thus not only generates tenure effects but also job to job mobility with wage cuts.
