Publication Date: June 1973
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.