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Equity, Options and Efficiency in the Presence of Moral Hazard

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  • Michael Magill

    (University of Southern California)

Abstract

This paper provides a general equilibrium analysis of an economy with production under uncertainty in which the firms' capital (ownership) structure creates a moral hazard problem for their managers. The paper studies the concept of an equilibrium with rational, competitive price perceptions (RCPP) in which investors correctly anticipate the optimal effort of entrepreneurs by observing their financial decisions, and entrepreneurs are aware that investors use their financial decisions as signals. The competitive element in the equilibrium valuation of firms comes from the fact that entrepreneurs cannot affect the market price of risks. It is shown that under appropriate spanning assumptions an RCPP is constrained Pareto optimal. Furthermore, if sufficiently many options are traded, then full optimality can be obtained despite the moral hazard problem: options serve both to increase the span of the market and to provide incentives for entrepreneurs.

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1845.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:1845

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  1. Michael Magill & Martine Quinzii, 2002. "Theory of Incomplete Markets, Volume 1," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262632543, January.
  2. Brander, James A & Spencer, Barbara J, 1989. "Moral Hazard and Limited Liability: Implications for the Theory of the Firm," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(4), pages 833-49, November.
  3. Magill, Michael & Shafer, Wayne, 1991. "Incomplete markets," Handbook of Mathematical Economics, in: W. Hildenbrand & H. Sonnenschein (ed.), Handbook of Mathematical Economics, edition 1, volume 4, chapter 30, pages 1523-1614 Elsevier.
  4. Ross, Stephen A, 1973. "The Economic Theory of Agency: The Principal's Problem," American Economic Review, American Economic Association, vol. 63(2), pages 134-39, May.
  5. Leland, Hayne E & Pyle, David H, 1977. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, American Finance Association, vol. 32(2), pages 371-87, May.
  6. 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.
  7. Sanford J. Grossman & Oliver D. Hart, 1982. "Corporate Financial Structure and Managerial Incentives," NBER Chapters, in: The Economics of Information and Uncertainty, pages 107-140 National Bureau of Economic Research, Inc.
  8. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
  9. Ross, Stephen A, 1976. "Options and Efficiency," The Quarterly Journal of Economics, MIT Press, vol. 90(1), pages 75-89, February.
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Cited by:
  1. Belen Jerez, 2000. "General Equilibrium with Asymmetric Information: A Dual Approach," Econometric Society World Congress 2000 Contributed Papers 1497, Econometric Society.
  2. Peter Bossaerts & Caroline Fohlin, 2000. "Universal Banking and the Pricing of Securities Risk: Historical Evidence from Germany," Econometric Society World Congress 2000 Contributed Papers 1596, Econometric Society.
  3. Wagner, W.B., 2000. "Decentralized International Risk Sharing and Governmental Moral Hazard," Discussion Paper 2000-92, Tilburg University, Center for Economic Research.
  4. Alessandro, CITANNA & Archishman, CHAKRABORTY, 1999. "Moral Hazard, Aggregate Risk and Nominal Linear Financial Contracts," Les Cahiers de Recherche 683, HEC Paris.

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