General equilibrium with endogenous securities and moral hazard

Summary. This paper studies a class of general equilibrium economies in which the individuals endowments depend on privately observed effort choices and the financial markets are endogenous. The environment is modeled as a two-stage game. Individuals first make strategic financial-innovation decisions. They then act in a Radner-type economy with the previously designed securities. Consumption goods, portfolios, and effort levels are chosen competitively (i.e., taking prices as given). An equilibrium concept is adapted for these moral hazard economies and its existence is proven. It is shown through an example how incentive motives might lead to the endogenous emergence of financial incompleteness.Received: 18 March 2002, Revised: 16 February 2004, JEL Classification Numbers: D52, D82, G10, G22.This paper is based on an essay from my Ph.D. dissertation at the University of Chicago. I am thankful for comments from Fernando Alvarez, Rodrigo Cerda, Pierre-André Chiappori, Rubens P. Cysne, Carlos E. da Costa, Milton Harris, Lars Stole, Juan P. Torres-Martínez, Paulo K. Monteiro, Philip Reny, Iván Werning, an anonymous referee, and seminar participants at the 6th SAET Conference and the 22th SBE Meeting. Financial support from CNPq is gratefully acknowledged.