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Working Paper

Limited Liability and the Development of Capital Markets

We study the consequences of the introduction of widespread limited liability for corporations. In the traditional view, limited liability reduces transactions costs and enhances investment incentives for individuals and firms. But this view does not explain several important stylized facts of the British experience, including the slow rate of adoption of limited liability by firms in the years following legal reforms. We construct an alternative model that accounts for this and other features of the nineteenth century British experience. In the model, project risk is private information, and a firm’s decision to adopt limited liability may be interpreted in equilibrium as a signal the firm is more likely to default. Hence less risky firms may choose unlimited liability or forego investments entirely. We show the choice of liability rule can lead to "development traps," in which profitable investments are not undertaken, through its effect on equilibrium beliefs of uninformed investors in the economy.

Suggested Citation

Nosal, Ed, and Michael Smart. 2007. “Limited Liability and the Development of Capital Markets.” Federal Reserve Bank of Cleveland, Working Paper No. 07-03.