Question

The island of Utopia has a very unusual economy. Everyone on Utopia knows everyone else and knows all about the firms they own and operate. The financial system is well developed on Utopia. Everything else being equal, how would you expect the mix on Utopia between internal finance (where companies use their own funds such as retained earnings) and external funding (where companies obtain funds through financial markets) to compare with other countries? What role would financial intermediaries play in this economy?

Answer 1

Because in Utopia people know each other well, including the firms that they own, and also because the financial system is well developed, one would expect that, compared to ther countries, the level of external funding to be way higher that the level of internal funding.

This is because as people hold symmetric information about the firms, they have the incentive to pool resources to the financial system in order to invest in the best options, and firms would likely make use of those resources, which will also likely be higher, than of their internal resources.

Financial intermediares would have the task of channeling the funds to the correct options, and also to develop financial instruments to attract even more investment, or to improve the returns of the existing investment.