The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment


  • David S. Scharfstein,

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    • MIT Sloan School of Management and NBER, and Harvard University and NBER, respectively. This paper is a completely overhauled version of our March 1997 NBER working paper (#5969) with the same title. We have received research support from the National Science Foundation and the Finance Research Center at MIT. We are grateful to Charlie Hadlock, Oliver Hart, Laurie Hodrick, Bengt Holmström, Preston McAfee, Vik Nanda, Julio Rotemberg, René Stulz, Dimitri Vayanos, Luigi Zingales, Jeff Zwiebel, the referees and seminar participants at Columbia, Harvard, Indiana, the NBER, Boston University, Utah, Ohio State, Stanford, Stockholm, Yale, the ASSA meetings, and the New York Fed for helpful comments. Thanks also to Melissa Cunniffe and Svetlana Sussman for help in preparing the manuscript.
  • Jeremy C. Stein


We develop a two-tiered agency model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent-seeking, division managers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of “socialism” in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.