The Stock Market in the Overlapping Generations Model with Production

This paper addresses the following question: does the stock market influence the process of capital accumulation? If exchanging ownership of firms on a stock market is equivalent to exchanging the ownership of their capital on a capital goods market, then introducing a stock market will not affect the predictions of the real models of capital accumulation–the Ramsey model (1928) if agents are infinitely lived, or Diamond's overlapping generations (OLG) model (1965) if agents are finitely lived. The assumption that ownership of firms is transferred through the stock market rather than the capital goods market can lead to a different outcome only if there is a friction which makes the stock market into a financial entity distinct from the real capital goods market. The friction that we study in this paper is the firm specificity of capital which makes it costly, if not impossible, to detach part of the tangible or intangible capital of a firm to sell it on a (secondhand) market for capital goods. To quote Tobin (1998, p. 147) " The various physical assets of a business enterprise are often designed, installed and used in complex combinations specific to the technology. It is costly or impossible to detach and move individual assets or to apply them to alternative purposes. " We take this observation to the theoretical limit by assuming that capital, once installed, is a sunk cost: it cannot be transformed back into a consumption good or used by other firms. Under this assumption, when capital is durable, firms must be long lived and if transferred, must be kept intact in their entirety. If, as we shall assume, economic agents are short lived, then there is a need for a market which makes such transfers possible, and this is one of the important roles of the stock market: each firm becomes a separate legal entity which issues equity shares to its future income stream, and ownership of firms can be transferred in perfectly divisible amounts across an indefinite succession of finite-lived shareholders, while retaining in perpetuity the full physical and organizational entity of the firm. 1 We are thus led to study the role of the stock market as an instrument for transferring firms in the setting of the standard Diamond model to which we add the friction that capital once installed in a firm cannot subsequently be sold (i.e. has a zero price) on the market …