Financial frictions, internal capital markets, and the organization of production

• Quantitative assessment of the allocative role of internal capital markets.
• Internal capital markets allow firms to avoid external credit market imperfections.
• Size and productivity differences of plants in conglomerates and single-segment firms.
• Business conglomeration reduces economy-wide misallocation.
• Business conglomeration has a positive impact on economic development.

This paper evaluates the role of internal capital markets in business groups for allocating capital to its most productive use. A quantitative model in which business groups arise endogenously as substitutes for imperfect credit markets explains several stylized facts about establishment size distribution and cross-firm productivity differences. The impact of internal capital markets on economic development is positive: shutting down business conglomeration in the model calibrated to the Canadian economy would lead to a 3 percent reduction in output per capita. These losses are higher in economies with less developed financial markets.