The concept of limited liability in corporate law is widespread all over the world. Limited liability means, that owners of a company can only loose their capital invested into the company - the shares - as opposed to being liable with their whole private equity. My question is simple:

Does this benefit the economy as a whole or is this just a legal trick by corporate crooks?

  • 1
    $\begingroup$ Being an entrepreneur can be quite risky and one can argue that entrepreneurs are important for innovation. Entrepreneurs also need investors. Since humans are typically risk and loss averse, one can argue for limited liability as helpful to promote innovation. $\endgroup$
    – Bayesian
    Jun 12 '19 at 20:34

It is beneficial (at least, mostly beneficial). Investments are risky, and business projects fail all the time at no fault of the entrepreneur. By bounding the risk profile of corporations, you give incentives for more people to start a business and look out for funding. Let me explain myself with a super simple example.

Suppose there was a project that has a 60% chance of being successful and create 10k jobs, and economic welfare to the community with a value estimated to be 500K Dollars. However, with 40% probability, it will fail and the initial investment of 150K Dollars will be lost. The entrepreneur lacks sufficient funds for the initial investment (let's assume it has to be fully funded by investors). If there was no limited liability, it is clear that most entrepreneurs will not do the project. Only entrepreneurs with sufficiently low risk aversion or sufficiently large pockets will be willing to raise the money (or use their own) and do the risky project with those odds.

You see that a project that is arguably welfare enhancer is not made, because it is too risky. Limited liability smooths things out by distributing the risk of a project among all the investors.

Clearly, this example is super simple and I have abstracted from principal-agent problems, entrepreneur fraud, situations where the success of the project depends on the entrepreneur's risk aversion, etc. There are many papers dealing with these issues (and others), but the main argument for limited liability is captured in this toy model. So yes, a very strong case can be made to conclude that it is beneficial.

  • 3
    $\begingroup$ Great answer. I'd just like to leave this very leyman-friendly article from 1999 about Limited Liability: economist.com/finance-and-economics/1999/12/23/…. $\endgroup$ Jun 16 '19 at 20:29
  • $\begingroup$ @Regio. Thanks for your answer. Are there also any papers to back up your claim? Also do you think if negative externalities are considered the concept would still be beneficial? $\endgroup$ Jun 17 '19 at 12:24
  • $\begingroup$ What exactly do you have in mind when you say negative externalities? Also I do not know the latest literature, but this paper might be a good starting point. You will also see that many papers assume limited liability as an unavoidable characteristic of entrepreneurial financing, so beware. $\endgroup$
    – Regio
    Jun 17 '19 at 16:37

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