Business Groups, the Financial Market and Modernization

Business groups are an important aspect of the industrial organization of many developing countries. This paper develops a theory suggesting that they may be organizations that facilitate modernization in the presence of financial market constraints. An important function of the stock market is the diversification of risk that comes with specialized, productive technology. But in the face of serious information problems a well functioning stock market may fail to emerge, relegating the economy to a low productivity-poverty trap. Bilateral links between a firm and a group of others may be a more cost-effective way to achieve risk-sharing. Such business groups may be feasible when a full-fledged stock market is not. As modernization takes place, either because information problems become less severe or more firms enter the economy, business groups actually expand in size before being abruptly rendered obsolete by the stock market. This is consistent with empirical results from a number of emerging economies.