Richard E. Kihlstrom

A General Equilibrium Entrepreneurial Theory of Firm Formation Based on Risk Aversion

We construct a theory of competitive equilibrium under uncertainty using an entrepreneurial model with historical roots in the work of Knight in the 1920s. Individuals possess labor which they can supply as workers to a competitive labor market or use as entrepreneurs in running a firm. All entrepreneurs have access to the same risky technology and receive all profits from their firms. In the equilibrium, more risk averse individuals become workers while the less risk averse become entrepreneurs. Less risk averse entrepreneurs run larger firms and economy-wide increases in risk aversion reduce the equilibrium wage. A dynamic process of firm entry and exit is stable. The equilibrium is efficient only if all entrepreneurs are risk neutral. Inefficiencies in the number of firms and in the allocation of labor to firms are traced to inefficiencies in the risk allocation caused by institutional constraints on risk trading. In a second best sense which accounts for these constraints, the equilibrium is efficient.

Advertising as a Signal

A great deal of advertising appears to convey no direct credible information about product qualities. Nevertheless, such advertising may indirectly signal quality if there exist market mechanisms that produce a positive relationship between product quality and advertising expenditures. Two models of this phenomenon are presented. In each, advertising signals quality in the short run. The models differ in their treatment of the effect of advertising on long-run sales. In the first, all high-quality firms ultimately establish reputations for high quality whether they advertise or not. This is shown to imply that advertising can signal quality if and only if high-quality production requires investments in specialized assets that increase fixed costs but not marginal costs. In the second model, where nonadvertising firms never acquire a reputation for high quality, advertising might signal quality even if marginal production costs are somewhat lower for low quality. These conclusions closely parallel arguments previously made by Phillip Nelson.

Managerial incentives in an entrepreneurial stock market model

Abstract This paper addresses the First Theorem of Welfare Economics in a moral hazard environment. An entrepreneur sells equity in a firm which he supplies with an unobservable, costly input. How much equity he retains determines his incentives and is observed by investors. The investors have rational expectaions which cause the equity price to increase in the amount of equity the entrepreneur retains. This gives the entrepreneur an incentive to retain equity and hence supply input. The entrepreneur may also be bound by an explicit incentive contract. In this framework, not all competitive equilibria are efficient, as defined relative to the moral hazard constraint. However, equilibria can be inefficient only if the entrepreneurs optimal input is nonunique or exhibits positive income effects.

Insurance and the Value of Publicly Available Information

A number of recent papers (e.g., Radner (1981, 1985), Townsend (1982), Rubinstein-Yaari (1983), Lambert (1983), Dionne (1983), and Rogerson (1985)) have studied the role of multi-period contracts in situations characterized by asymmetrically informed agents. In the circumstances envisaged by this literature, multi-period contracts perform no useful function when agents are equally well-informed.1 The present paper considers a different set of circumstances and shows that multi-period contracts may be useful even when agents are symmetrically informed.

Implicit Labor Contracts and Free Entry

The model investigated here is an adaptation of the free-entry model introduced in Kihlstrom-Laffont [1979]. In that model the only labor market is one in which employers pay workers an ex ante guaranteed wage. In the model of this paper, there is also a spot market for labor. In the earlier sections of the paper, the existence of the equilibrium is established, and its efficiency is investigated. In this analysis it is assumed that all individuals are identical. In the later sections we drop this assumption and investigate conditions under which employers are more risk-averse than workers.

Collusion by asymmetrically informed duopolists

Abstract We investigate the possibility of incentive compatible and individually rational collusion in a duopolistic industry in which each firm knows its own costs but not the cost of the other firm. Sidepayments are assumed to be possible, and two forms of individual rationality constraints, ‘interim’ and ‘ex post’ are considered. We describe the restrictions imposed on the sidepayments by each from of the individual rationality conditions and by the incentive compatibility conditions. We demonstrate that it is possible to devise sidepayment schemes that simultaneously satisfy the incentive compatibility constraints and the interim individual rationality constraints. We also demonstrate that it is possible to devise sidepayment schemes that simultaneously satisfy the incentive compatibility constraints and the ex post individual rationality constraints. We finally demonstrate that, in general, it may not be possible to devise sidepayments that simultaneously satisfy both forms of the individual rationality constraints.

Term premia in a simple term structure model

Abstract The present paper is an extension of Stiglitzs (1970) analysis. We use variations of his original model in an attempt to relate his contribution to the more recent literature. Our main purpose is to determine the nature of the term premium implied by various forms of the utility maximization hypothesis. Our focus is primarily on what Cox, Ingersoll, and Ross (CIR) (1981) call the returns to maturity expectation hypothesis , although we also investigate the local expectation hypothesis , which is the central focus of the analysis in CIR (1981). We study the conditions under which this hypothesis holds, and when it does not hold, we attempt to determine the direction of the resulting inequality. We are able to obtain results for the case in which the demand for long bonds is positive and to compare these results to others obtained when long bond demand is zero, the case studied in the recent literature.