5 Some Extensions and Generalizations
5.1 Remarks on Welfare Analysis
It would be desirable to perform some welfare analysis on the above model.
However, much depends on the social desirability of introducing competition
to an industry, which has not so far been specified. In general, competition will
improve consumer welfare ex-post through higher output and lower prices, so
that one might suppose that it would be desirable for financial regulators to try
to prevent investors from solving the Coase problem. But if the entrepreneur
has a high reservation wage, he might be deterred from entering the industry
at all if the Coase problem cannot be solved. For example, if:
VM >W>V1C
then the entrepreneur can be persuaded to enter the industry only if he can be
guaranteed a monopoly position. In this case regulation making the solution
of the Coase problem more difficult would prevent the emergence of this new
industry. Thus one might suppose that the social optimum would be achieved
by a policy of allowing investors to hold equity in situations where it is impor-
tant to allow monopoly rents, e.g. as a reward to innovation, but to prevent
them from doing so otherwise. This is simply another guise of the familiar
Schumpeterian trade-off. Using this scheme and the results of our model, it
may be interesting to speculate about the regulation governing investments
by banks in different countries. We pursue this issue more fully and provide
more evidence in section 6.1. However, we feel that any welfare analysis of
the effects of using different types of financial claims is incomplete if it does
not take into account the fact that if deprived of one potential instrument for
solving the Coase problem, investors may use other, more costly means to do
so. In the following subsection, we briefly mention one alternative solution to
the over-funding problem.
5.2 Lack of Monitoring by Investors
Let us assume that Firm 2’s project may be of two types. With probability α
the project is “good”, in which case funding Firm 2 yields V2 to the investor.
With probability (1 - α) the project is “bad”, and it yields to the investor
V2 < 0. Assume that in the process of funding firm 1, the investor may observe
a signal about Firm 2’s profitability, i.e. he may find out whether Firm 2 is
good or bad. Now suppose we make the additional assumption that:
αV2 + (1 - α)V2 < 0
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