Returns-to-scale and the equity premium puzzle
A model of heterogenous firms facing idiosyncratic risk is proposed which generates an equity premium of 6 per cent and a risk-free rate of 1.5 per cent even if aggregate returns are risk-free. The premium in this model reflects diminishing returns-to-scale and the fact that equity shares are equal claims to firm output. In the bond market, the risk-free rate reflects trade in assets at marginal rates of return with a linear technology and thus the equity premium in excess returns reflects a comparison of average returns with marginal returns. In the model, credit constraints lower the equity premium and, absent such constraints, the equity premium would roughly double. Since the model may be interpreted as a model of entrepreneurship, this paper also presents estimates from a structural model of entrepreneurship using data from the Survey of Consumer Finances and also finds only a modest level of risk aversion is sufficient to replicate entrepreneurial returns.
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