Changes in the Financial Market: Welfare and Price Effects and the Basic Theorems of Value Conservation

Abstract

This paper analyzes the impact, on both welfare and equilibrium prices, of changes in the financial market in a general equilibrium, two-period context. Previous papers have focussed on the securities effect, tending to essentially ignore the equally important effect that arises when market structure changes are implemented. Two forms of endowment neutrality and market structure changes which either preserve, expand, or shift allocational feasibility differentiate the main theorems, which are based on arbitrary preferences and beliefs and substantially extend and modify extant results; in particular, earlier statements identified with value conservation are sharply moderated. Very roughly, the paper yields the following implications for some of the more common changes in the market: nonsynergistic corporate spinoffs and the opening of option markets have, on balance, strongly positive welfare effects; nonsynergistic mergers tend to have strong negative welfare effects, while the welfare effects of alternative risky debt structures tend to be ambiguous. All of the preceding, however, may under plausible conditions be redistributive. CHANGES IN THE STRUCTURE of the financial market have long been of interest to financial economists. While such changes may take many forms, it is perhaps surprising that only a few of the more common ones have been systematically studied. Foremost among these are changes which involve the firm's capital structure (the relative amounts of debt and equity), mergers, and other special recapitalizations. This paper analyzes the impact, on both welfare and equilibrium prices, of changes in the financial market in a two-period context. It differs from previous studies primarily in that it is based on a fully integrated (general equilibrium) approach similar to that employed in international trade analysis. Thus, while the resulting mosaic contains previous studies as clearly recognizable fragments, such as the classic paper of Modigliani and Miller [33], it also provides the necessary framework and tools for an evaluation of market structure changes of any type, such as changes involving subordinated debt, convertibles, warrants, mergers, spinoffs, and the opening of option markets.