Distance to frontier and optimal financial structure

Abstract

This paper studies endogenous change of financial institutions in a Schumpeterian endogenous growth model with uncertain innovation outcome. Technological progress can result from either imitation or innovation. Information about each innovative project can be acquired by paying a fixed cost. Financial intermediaries save the information cost through delegation yet incur an agency cost that results from diversity of opinion. Investors thus face a tradeoff between the information and agency cost. Because the information and agency cost is proportional to the technological frontier and the local technology level respectively, saving the information cost dominates in the early stages of development when the distance to frontier is large. In contrast, avoiding the agency cost dominates as the local technology level approaches the frontier. As a result, economic development is accompanied by a gradual switching of financial structure from intermediaries to markets.