Financial Innovation, Communication and the Theory of the Firm
Zurich IEER Working Paper No. 32
38 Pages Posted: 20 Jul 2000
Date Written: February 2000
When markets are incomplete, the competitive equilibria considered so far are not constrained Pareto-efficient, production efficiency breaks down and shareholders no longer agree on the objective function of the firm. We first show by way of an example that these inefficiencies originate in the double role of firms in incomplete markets: providing high market value and providing good hedging opportunities (spanning role). To disentangle these two conflicting roles of the firm's decision, we then suggest to let the firm choose a relevant financial policy by issuing securities being collaterized by the production plan. In order to guarantee that the firm does not choose to innovate trivial assets, it is then shown to be crucial that the firm's shareholders agree on the same set of beliefs. Therefore we introduce some communication network into the model which allows the shareholders to exchange their views on the firm's best policies. In our main result we demonstrate that competitive equilibria with communication of shareholders and a relevant financial policy of the firm are Pareto-efficient, provided there are at least as many firms as there are shareholders.
Keywords: theory of the firm, incomplete markets, communication, financial innovation
JEL Classification: D21, D52, G32, L21
Suggested Citation: Suggested Citation