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 [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

Agency Costs, Risk Management, and Capital Structure.

The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani-Miller), and the agency costs resulting from asset substitution (Jensen-Meckling). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is relatively small for the range of environments considered. Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low.

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 [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.