Discussion Paper Series 2011-E-7

Equity Sales and Manager Efficiency Across Firms and the Business Cycle

Fabio Ghironi, Karen K. Lewis

Smaller firms sell more equity in response to expansions than do larger firms. Also, consumption is more pro-cyclical for high income groups than others. In this paper, we present a model that captures key features of both of these patterns found in recent empirical studies. Managers own firms with unique differentiated products and can sell ownership in these firms. Equity sales require paying consulting fees, but the resulting scrutiny also make firms more efficient. We find four main results: (1) Equity sales are pro-cylical since the benefits of efficient production outweigh the consulting fees during a boom. (2) Equity shares in smaller firms are more pro-cyclical because expansions make previously solely-owned firms to seek outside equity financing. (3) Households must absorb the increased equity sales by managers, thereby affecting their consumption response relative to managers. (4) Greater underlying managerial inefficiency induces more firms to seek outside advice and ownership in equilibrium. As a result, the cyclical impact on efficiency is mitigated by outside ownership.

Keywords: Equity Sales; Managerial Efficiency; Firm Size; Business Cycles

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2011 Bank of Japan All Rights Reserved.

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