Ethics, welfare, and capital markets

•Interaction between entrepreneurs and investors.•An agent chooses whether to develop a moral conscience.•More guilt-based societies show more expropriation and a lower net price of capital.•Also, smaller firms, decreased capital inflows and less social welfare.•The results of a smaller emphasis on pride are in the same direction.

We examine implications of a society's cultural emphasis on moral sentiments. Entrepreneurs and investors interact in a game that entails both adverse selection and moral hazard; entrepreneurs may attempt to breach their contracts and expropriate investors. An agent is born into a particular culture but chooses whether to develop a moral conscience and thereby subject himself to moral sentiments. In equilibrium, societies that place less emphasis on guilt exhibit a lower risk of expropriation in contracts, a greater net price of capital, a larger size of firms, increased capital inflows and greater social welfare. The results of a greater emphasis on pride are in the same direction.