Mis-allocation Within Firms: Internal Finance and International Trade

Abstract: We offer a novel theory of mis-allocation within firms (rather than between firms) due to manager‘s empire building. We introduce an internal capital market in which managers of multi-product firms compete for funds weithin their firms in a two factor model of multi-product firms with monopolistic competition. Our theory explains why exporters suffer from a lower conglomerate discount than domestic firms (a novel fact that we establish). We show that more open markets impose discipline on internal competition for capital weithin firms, thus improving the efficiency of internal capital markets. Calibrating the model to US data shows that a 35% reduction in trade costs reduces, on average, the excessive financing in the best divisions of multi-product firms from 40% to 6%.