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A Theory of Competitive Equilibrium in Stock Market Economies

Sanford J. Grossman
Oliver D. Hart

Abstract

In an economy with incomplete markets, firms' profits at different dates and contingencies cannot be aggregated into a single index and so profit maximization is not well-defined. In this paper we propose an objective for firms to pursue which is a generalization of the idea of profit maximization. We show that, if firms' managers can transfer current income between shareholders at the first date, and if shareholders have what we call competitive perceptions concerning the effect of a change in production plan on share prices, then each firm will maximize a weighted sum of shareholders' private valuations of the firm's production plan, where the weights are the initial shareholdings. We then define, and prove the existence of, a competitive equilibrium in which firms pursue this proposed objective. Finally, we analyze the optimality properties of the competitive equilibrium.