Question

Some economists say the lack of well-developed financial markets explains why the economies of developing countries grow rather slowly. True or false? Explain your response with a suitable framework, with emphasis on allocative efficiency and marginal productivity of capital.

Answer 1

It is true.

A developed financial market provides a platform that brings seekers of the funds and providers of the funds together and channelization of funds take place. A faster channelization reflects an increase in productive activities that benefits to all the parties involved in the channelization. For example, a bank takes deposits from the investors and pay them, interest rates. These deposits are issued to the businesses and higher interest rate is charged. Now, all three parties gain as depositors gain some interest income, businesses start production of goods and services and the bank gets interest rate income due to the margin of interest rate charged and the interest rate paid. Such channelization of funds can be further accelerated by the development of bond market, equity market, money market or other financial instruments that can channelize the funds. All these markets and instruments bring different rate of return and interests with different risk profiles. Hence the allocative efficiency is achieved when a well-developed market gives different opportunities to the investors on the basis of risk and return profile. Firms also get the funds that are required to produce the profit maximizing output where MR = MC. At this level, the marginal productivity of capital is also efficient in the economy as different investors get different return of their choice, provided they take the risk. It only happens through the well-developed financial market where the regulations help to protect the interests of the investors. In the absence of such developed market, channelization becomes very difficult and people & firm neither achieve allocative efficiency for their capital, nor the adequate MPk is achieved. So, economy suffers from the laggardness.