Product Market Efficiency: The Bright Side of Myopic, Uninformed, and Passive External Finance

We show that introducing an external capital market with information asymmetry into a product market model reduces opportunistic substitution of sub-standard goods and encourages producers to concentrate on long-run reputation building. We test this result with a laboratory experiment. We find that, when the problem of product market opportunism is moderate, i.e., reputation formation equilibria exist when firms raise external funds but not when they rely on internal funds, external financing results in much higher (roughly double) economic surplus. This external finance premium results primarily from higher levels of output caused by the reduced likelihood or market failure. JEL Classification Codes: C91, D82, G31, G32, L15;