Capital market equilibrium with moral hazard

This paper studies a general equilibrium model of an economy with production under uncertainty in which firms’ capital (ownership) structures creates a moral hazard problem for their managers. The concept of an equilibrium with rational, competitive price perceptions (RCPP) is introduced, 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. © 2002 Elsevier Science B.V. All rights reserved.