Capital Misallocation and Risk Sharing joint with Hengjie Ai, Yuchen Chen, and Ying Chao

Abstract:

This paper shows that factor misallocation is closely tied to the risk-sharing avenues available to firm owners. In contrast to the commonly studied bond-only economy with collateral constraints (for example Moll (2014), we find that the degree of misallocation is emph {increasing} in persistence of the idiosyncratic risk when firms have access to state-contingent contracts. The possibility to transfer wealth from high productivity states to low productivity states allows firm owners to trade off efficient allocation of consumption against efficient allocation of capital. We show that for reasonable values of risk aversion, insurance needs more than offset production efficiency concerns and thereby generates large capital misallocation.