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Equity, Options and Efficiency in the Presence of Moral Hazard

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Michael Magill (University of Southern California)

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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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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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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. 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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  2. Stephen A. Ross, 1977. "The Determination of Financial Structure: The Incentive-Signalling Approach," Bell Journal of Economics, The RAND Corporation, vol. 8(1), pages 23-40, Spring. [Downloadable!] (restricted)
  3. 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)
  4. Bisin, A. & Gottardi, P., 1997. "General Competitive Analysis with Asymmetric Information," DELTA Working Papers 97-26, DELTA (Ecole normale supérieure).
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  5. 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. [Downloadable!] (restricted)
  6. Ross, Stephen A, 1976. "Options and Efficiency," The Quarterly Journal of Economics, MIT Press, vol. 90(1), pages 75-89, February. [Downloadable!] (restricted)
  7. 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. [Downloadable!] (restricted)
  8. 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. [Downloadable!] (restricted)
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  9. Michael Magill & Martine Quinzii, 2002. "Theory of Incomplete Markets, Volume 1," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262632543.
  10. Roy Radner, 1974. "A Note on Unanimity of Stockholders' Preferences among Alternative Production Plans: A Reformulation of the Ekern-Wilson Model," Bell Journal of Economics, The RAND Corporation, vol. 5(1), pages 181-184, Spring. [Downloadable!] (restricted)
  11. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September. [Downloadable!] (restricted)
  12. 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. [Downloadable!]
  13. 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. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Alessandro, CITANNA & Archishman, CHAKRABORTY, 1999. "Moral Hazard, Aggregate Risk and Nominal Linear Financial Contracts," Les Cahiers de Recherche 683, HEC Paris. [Downloadable!]
  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. [Downloadable!]
  3. Fohlin, Caroline & Bossaerts, Peter, 2000. "The Pricing of Securities Risk in a Universal Banking System: Historical Evidence from Germany," Working Papers 1084, California Institute of Technology, Division of the Humanities and Social Sciences. [Downloadable!]
  4. Wagner, W., 2000. "Decentralized international risk sharing and governmental moral hazard," Discussion Paper 92, Tilburg University, Center for Economic Research. [Downloadable!]
  5. Bel? Jerez, 2000. "General Equilibrium with Asymmetric Information: a Dual Approach," UFAE and IAE Working Papers 510.02, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC). [Downloadable!]
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