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Can socialism in internal capital markets occur in the absence of managerial rent seeking?

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Socialism in internal capital markets (SICM) is the phenomenon whereby multi-division firms underinvest in high-profit segments and overinvest in low-profit segments. This article modifies and extends the Scharfstein and Stein (2000) model that explains SICM. The major modification is to abstract from rent-seeking behaviour - a central ingredient that is used by most SICM models and has the side effect of overturning SICM when the underlying rent-seeking game is slightly perturbed. It is shown that when division managers' private benefits are not exactly propotional to their division's production profit, as assumed by Scharfstein and Stein (2000), SICM arises due to the CEO's incentive to extract gain from the trade of capital between his division managers by equalizing their marginal private benefits, instead of accommodating rent-seeking. Furthermore, we show that 'diversification discounts' exist, increase in diversity and decrease in CEO ownership. The results are robust to endogenizing the investors' choice of the total capital provided to the firm, which allows the conditions for aggergate underinvestment or overinvestment to be determined.
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Document Type: Research Article

Affiliations: Department of Economics, National Tring Hua University, Hsinchu, Taiwan - Republic of China

Publication date: 01 January 2010

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