Firm Objectives Under Incomplete Markets

It is a well-known fact that under incomplete financial markets the preferences of shareholders matter for the objective of the firm, and maximization of expected profits is not well-defined. Shareholders may be different in their risk aversion, wealth or share endowments, which leads to different valuations of future payoffs and thus their desired investment decisions. In a simple model with two agents operating one firm we introduce the following collective choice mechanism for the investment decision: Agent 1, holding a majority and representing the control group, decides on the amount of investment in its own interest but is restricted to give a minimal satisfaction to the minority shareholders (represented by agent 2). Afterwards, both agents may trade at the stock market. The objective is to compare outcomes in terms of investment, firm value and final shareholdings to those implied by other firm objectives such as maximization of ex-pected profits, the criterion of Grossman and Hart (1979), utility maximization of a single entrepreneur and a constrained planner solution. ∗I thank Branko Uroševic ́ for his advice, and Albert Marcet and Christopher Telmer for comments. All errors and omissions are there thanks to myself. Correspondence