Equilibrium Equity Premium, Interest Rate and the Cost of Capital in a Single-Firm Economy under Moral Hazard∗

We present an equilibrium model of a moral-hazard economy with one firm and financial markets, where a stock and bonds are traded. We show that it is optimal for the principal to forbid the agent to trade the stock; that the second-best interest rate is lower than the first-best interest rate; and that the second-best equity premium can be higher or lower than the first best equity premium. We also obtain a number of striking results. In full equilibrium, even in the absence of the well-known empire-building motivation, moral hazard can sometimes result in overinvestment. Unlike conventional wisdom, moral hazard can decrease the cost of capital of the economy. Moreover, the second-best market price of risk depends not only on well-known factors such as risk aversion and production-asset volatility, but also on the agent’s marginal effort productivity and marginal cost of effort. JEL classification: D51, D53, D86, G11, G12, G31.