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.