Limited Capital Market Participation and Human Capital Risk

TLDR

Limited capital market participation can be an equilibrium outcome when labor contracts are endogenously derived and capital markets facilitate risk sharing between firms and workers. Firms write labor contracts that insure workers, enabling a Pareto‑optimal allocation even with only stocks and bonds available. Investing in capital markets provides insurance to wage earners, who then optimally choose not to participate in those markets. JEL codes: G11, G12.

Abstract

By introducing a labor market into the neoclassical asset pricing model, limited capital market participation can be an equilibrium outcome. Labor contracts are derived endogenously as part of a dynamic equilibrium in a production economy. Firms write labor contracts that insure workers, allowing agents to achieve a Pareto optimal allocation even when the span of asset markets is restricted to just stocks and bonds. Capital markets facilitate this risk sharing because it is there that firms offload the labor market risk they assumed from workers. In effect, by investing in capital markets, investors provide insurance to wage earners who then optimally choose not to participate in capital markets. (JEL G11, G12)