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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 [13], Lintner [10], and Mossin [11], 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 [4], Stiglitz [14], and Wilson [17], [18] on the optimality of stock prices.

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File URL: http://cowles.econ.yale.edu/P/cd/d03b/d0361.pdf
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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 361.

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Length: 31 pages
Date of creation: 1973
Date of revision:
Handle: RePEc:cwl:cwldpp:361

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References

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  1. 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.
  2. 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.
  3. Steinar Ekern & Robert Wilson, 1974. "On the Theory of the Firm in an Economy with Incomplete Markets," Bell Journal of Economics, The RAND Corporation, vol. 5(1), pages 171-180, Spring.
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Cited by:
  1. 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.
  2. David P. Baron, 1977. "On the Relationship Between Complete and Incomplete Financial Markets Models," Discussion Papers 241, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  3. Merton, Robert C., 1993. "On the microeconomic theory of investment under uncertainty," Handbook of Mathematical Economics, in: K. J. Arrow & M.D. Intriligator (ed.), Handbook of Mathematical Economics, edition 4, volume 2, chapter 13, pages 601-669 Elsevier.
  4. Lemma W. Senbet & Robert A. Taggart, Jr., 1984. "Capital Structure Equilibrium under Incomplete Market Conditions," NBER Working Papers 0747, National Bureau of Economic Research, Inc.
  5. Mich Tvede & Hervé Crès, 2001. "Proxy fights in incomplete markets: when majority voting and sidepayments are equivalent," Sciences Po publications 726/2001, Sciences Po.
  6. Ramser, Hans Jürgen, 1975. "Neuere Ansätze in der Theorie der Firma und ihre wettbewerbspolitischen Implikationen," Discussion Papers, Series 1 70, University of Konstanz, Department of Economics.
  7. Roger H. Gordon, 1981. "Taxation of Corporate Capital Income: Tax Revenues vs. Tax Distortions," NBER Working Papers 0687, National Bureau of Economic Research, Inc.
  8. Bosshardt, Donald I., 2003. "Capital structure, investment unanimity, and public goods: the case for social responsibility," The Quarterly Review of Economics and Finance, Elsevier, vol. 43(2), pages 239-260.
  9. CRES, Herve & TVEDE, Mich, 2001. "Proxy fights in incomplete markets: when majority voting and sidepayments are equivalent," Les Cahiers de Recherche 726, HEC Paris.
  10. Bejan, Camelia, 2008. "Production and financial decisions under uncertainty," MPRA Paper 11033, University Library of Munich, Germany.
  11. repec:spo:wpecon:info:hdl:2441/10282 is not listed on IDEAS

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