The Optimality of a Competitive Stock Market

Robert Merton and Marti G. Subrahmanyam

Bell Journal of Economics, 1974, vol. 5, issue 1, 145-170

Abstract: The findings of Jensen-Long and Stiglitz on the optimality of the stock market allocation have led to a controversy over whether the sources of the nonoptimality of value maximization are noncompetive assumptions about the capital market or are inherent externalities associated with uncertainty which do not disappear even in a competitive market. At least, for the mean-variance model with constant returns to scale technologies, we claim that the answer is the former, and that the sources of the nonoptimality are nonpricetaking behavior by firms, restrictions on the availability of technologies to firms, and restrictions on the number of firms that can enter. Using both tatonnement and nontatonnement processes, it is shown that if firms value maximize, then the Jensen-Long and Stiglitz equilibria are unstable with respect to the number of firms. If the restrictions on the availability of technologies and on the number of firms that can enter are relaxed, then the equilibrium will be a Pareto optimum in most cases, and in no case will the aggregate amount of investment be less than the Pareto optimal amount. If firms act as price takers (with or without the other restrictions), then the equilibrium is a Pareto optimum

Date: 1974
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