Integrating Real and Financial Decisions of the Firm

Abstract

We study the issue of integrating real and financial decisions in a monopoly firm with risk-averse decision-makers. To that end, we combine the decisions of the firm and of the shareholders in a very simple but robust model, with uncertainty in the real market and CARA preferences. We show the existence of equilibrium either in a competitive and a uncompetitive financial market, though different assumptions are needed in each case. In all situations, access to the financial market leads to risk-sharing and an increase in production, but only the competitive case is Pareto optimal. When either the firm or the outside investors act as leaders, the optimal risk-sharing is distorted to favor the leader. We also discuss the effect that changes on the coefficients of risk aversion have on the equilibrium outcomes.

Keywords: Existence of Equilibrium, Financial sector, Firm behavior, Market power, Monopoly, Nash equilibrium, Perfect competition, Publicly-traded firm, Risk aversion, Risk taking, Shareholder behavior, Stackelberg equilibrium

JEL Classification: D21, D42, D82, D83, D84, L12, L15