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Normative Properties of Stock Market Equilibrium with Moral Hazard

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Quinzii, Martine (U of California, Davis)
Magill, Michael (U of Southern California)

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Abstract

This paper presents a model of stock market equilibrium with a finite number of corporations and studies its normative properties. Each firm is run by a manager whose effort is unobservable and influences the probabilities of the firm's outcomes. The Board of Directors of each firm chooses an incentive contract for the manager which maximizes the firm's market value. With a finite number of firms, the equilibrium is constrained Pareto optimal only when investors are risk neutral and firms' outcomes are independent. The inefficiencies which arise when investors are risk averse, or when firms are influenced by a common shock, are studied and it is shown that under reasonable assumptions there is under investment in effort in equilibrium. The inefficiencies exist when the firms are not completely negligible, as is typical of the large corporations with dispersed ownership traded on public exchanges in the US. In the idealized case where firms of each type are replicated and replaced by a continuum of firms of each type with independent outcomes, the inefficiencies disappear.

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Paper provided by University of California at Davis, Department of Economics in its series Working Papers with number 08-2.

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Date of creation: Jan 2008
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Handle: RePEc:ecl:ucdeco:08-2

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  1. Marco LiCalzi & Sandrine Spaeter, 2003. "Distributions for the first-order approach to principal-agent problems," Economic Theory, Springer, vol. 21(1), pages 167-173, 01. [Downloadable!] (restricted)
  2. Grossman, Sanford J & Hart, Oliver D, 1979. "A Theory of Competitive Equilibrium in Stock Market Economies," Econometrica, Econometric Society, vol. 47(2), pages 293-329, March. [Downloadable!] (restricted)
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  3. Alberto Bennardo & Pierre-Andre Chiappori, 2003. "Bertrand and Walras Equilibria Under Moral Hazard," Levine's Working Paper Archive 618897000000000748, David K. Levine. [Downloadable!]
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  4. Steinar Ekern & Robert Wilson, 1974. "On the Theory of the Firm in an Economy with Incomplete Markets," Bell Journal of Economics, The RAND Corporation, vol. 5(1), pages 171-180, Spring. [Downloadable!] (restricted)
  5. Pradeep Dubey & John Geanakoplos, 2001. "Competitive Pooling: Rothschild-Stiglitz Reconsidered," Cowles Foundation Discussion Papers 1346R2, Cowles Foundation, Yale University, revised Feb 2002. [Downloadable!]
  6. Prescott, Edward C & Townsend, Robert M, 1984. "General Competitive Analysis in an Economy with Private Information," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 25(1), pages 1-20, February. [Downloadable!] (restricted)
  7. Michael Magill & Martine Quinzii, 2006. "Common Shocks and Relative Compensation," Annals of Finance, Springer, vol. 2(4), pages 407-420, October. [Downloadable!] (restricted)
  8. Paul R. Milgrom, 1981. "Good News and Bad News: Representation Theorems and Applications," Bell Journal of Economics, The RAND Corporation, vol. 12(2), pages 380-391, Autumn. [Downloadable!] (restricted)
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  9. Prescott, Edward C & Townsend, Robert M, 1984. "Pareto Optima and Competitive Equilibria with Adverse Selection and Moral Hazard," Econometrica, Econometric Society, vol. 52(1), pages 21-45, January. [Downloadable!] (restricted)
  10. Magill, Michael & Quinzii, Martine, 2002. "Capital market equilibrium with moral hazard," Journal of Mathematical Economics, Elsevier, vol. 38(1-2), pages 149-190, September. [Downloadable!] (restricted)
  11. James A. Mirrlees, 1976. "The Optimal Structure of Incentives and Authority Within an Organization," Bell Journal of Economics, The RAND Corporation, vol. 7(1), pages 105-131, Spring. [Downloadable!] (restricted)
  12. Kocherlakota, Narayana R., 1998. "The effects of moral hazard on asset prices when financial markets are complete," Journal of Monetary Economics, Elsevier, vol. 41(1), pages 39-56, February. [Downloadable!] (restricted)
  13. Mookherjee, Dilip, 1984. "Optimal Incentive Schemes with Many Agents," Review of Economic Studies, Blackwell Publishing, vol. 51(3), pages 433-46, July. [Downloadable!] (restricted)
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