Incentives and Risk Sharing in a Stock Market Equilibrium

Abstract

Economists hold two opposing views of the stock market: one focuses on the negative effect on incentives of separating ownership and control, the other emphasizes its beneficial role for risk sharing. Using a generalization of Diamond's model which incorporates the effect of entrepreneurial incentives, we show how these two views can be reconciled. We introduce the concept of a stock market equilibrium with rational competitive price perceptions (RCPP) and show that such and equilibrium leads to a constrained optimal trade-off between risk sharing and incentives. We give examples showing the difference between RCPP equilibria and the standard CAPM type equilibria of finance.

JEL Classification: D52, G32.