Theory of the Firm: Bargaining and Competitive Equilibrium

Abstract:     
Suppose that a firm has several owners and that the future is uncertain in the sense that one out of many different states of nature will realize tomorrow. An owner's time preference and risk attitude will determine the importance he places on payoffs in the different states. It is a well-known problem in the literature that under incomplete asset markets, a conflict about the firm's objective function tends to arise among its owners. In this paper, we take a new approach to this problem, which is based on non-cooperative bargaining. The owners of the firm play a bargaining game in order to choose the firm's production plan and a scheme of transfers which are payable before the uncertainty about the future state of nature is resolved. We analyze the resulting firm decision in the limit of subgame-perfect equilibria in stationary strategies. Given the distribution of bargaining power, we obtain a unique prediction for a production plan and a transfer scheme. When markets are complete, the production plan chosen corresponds to the profit-maximizing production plan as in the Arrow-Debreu model. Contrary to that model, owners typically do use transfers to redistribute profits. When markets are incomplete, the production plan chosen is almost always different from the standard notion of competitive equilibrium and again owners use transfers to redistribute profits. Nevertheless, our results do support the Drèze criterion as the appropriate objective function of the firm.

Number of Pages in PDF File: 34

Keywords: Strategic bargaining, Nash bargaining solution, incomplete markets, stock market equilibrium, objective function of the firm, profit-maximization

JEL Classification: C78, D52

working papers series