Capital market equilibrium with moral hazard and flexible technology

Magill and Quinzii show that for any economy for which the state space is technological (the vector of firms' outputs distinguishes states), there is a security structure consisting of the riskless bond, the equity of each firm, an index of equity contracts and an appropriately-chosen family of options under which the market structure satisfies the First and Second Welfare Theorems. The object of the present paper is to extend the analysis of Magill and Quinzii to the case of a stochastic production function with multiple inputs. We show that the conflict between the market structure satisfies the First and Second Welfare Theorems if and only if, for each firm, the number of linearly independent combinations of securities having payoffs correlated with, but not dependent on, the firms output is equal to the number of degrees of freedom in the firm's production technology.