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Production Theory and the Stock Market

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  • Hayne E. Leland

Abstract

Traditional economic models separate firms' production decisions from equilibrium in stock markets. In this paper, we develop an integrated model of production in the presence of capital asset market equilibrium. Our theory indicates that, in a stochastic environment, production and financial variables are inextricably interrelated. Following the financial equilibrium models of Sharpe, Lintner, and Mossin, we assume that profits and therefore portfolio returns are random. But stockholders can alter their distributions of returns by altering firms' production decisions as well as by altering their portfolios. The key to the analysis is a "unanimity theorem," which shows that in many environments stockholders will agree on optimal output decisions, despite their different expectations and attitudes towards risk. We develop equilibrium conditions which must be satisfied by production decisions. Profit maximization is indeed optimal for a firm whose profits are riskless. But risky firms' outputs depend on financial as well as cost variables, and the equilibrium conditions lead to a theory of production under uncertainty which replaces the now-vacuous notion of profit maximization. We further show that the output decisions will be Pareto optimal for stockholders, and that these decisions maximize market value only in a "purely competitive" world. Our results provide a synthesis of the conflicting conclusions of Diamond, Stiglitz, and Wilson on the optimality of stock markets.

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Bibliographic Info

Article provided by The RAND Corporation in its journal Bell Journal of Economics.

Volume (Year): 5 (1974)
Issue (Month): 1 (Spring)
Pages: 125-144

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Handle: RePEc:rje:bellje:v:5:y:1974:i:spring:p:125-144

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  1. Baron, David P, 1970. "Price Uncertainty, Utility, and Industry Equilibrium in Pure Competition," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 11(3), pages 463-80, October.
  2. Sandmo, Agnar, 1971. "On the Theory of the Competitive Firm under Price Uncertainty," American Economic Review, American Economic Association, vol. 61(1), pages 65-73, March.
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Cited by:
  1. Roger H. Gordon, 1981. "Taxation of Corporate Capital Income: Tax Revenues vs. Tax Distortions," NBER Working Papers 0687, National Bureau of Economic Research, Inc.
  2. Gordon Roger H., 2003. "Do Publicly Traded Corporations Act in the Public Interest?," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 3(1), pages 1-20, June.

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