Production Theory and the Stock Market
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 prices.
|Date of creation:||1973|
|Date of revision:|
|Contact details of provider:|| Postal: Yale University, Box 208281, New Haven, CT 06520-8281 USA|
Phone: (203) 432-3702
Fax: (203) 432-6167
Web page: http://cowles.yale.edu/
More information through EDIRC
|Order Information:|| Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA|
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- 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.
- 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.
- 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.
When requesting a correction, please mention this item's handle: RePEc:cwl:cwldpp:361. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Matthew C. Regan)
If references are entirely missing, you can add them using this form.