The conceptual foundations and technical apparatus of the theory of the firm require an understanding of the financial statements that describe the firm's economic position and structure. These are its periodic balance sheet and income statement. The examination of these documents establishes a linkage between the theory of the firm and an important dichotomy employed in many parts of economic analysis. This is the distinction between stock variables and stock analysis on the one hand and flow variables and flow analysis on the other.

On this important matter, the theory of the firm has been ambivalent. Following the recrudescence of interest in the firm's optimization problems in the 1930s, the distinguished economist Kenneth Boulding could still say, in the first edition of his A Reconstruction of Economics in 1950, that “the concept of the balance sheet, unfortunately, has not been employed to any extent in developing the static theory of the firm, so that as generally presented in the textbooks the firm is a strange bloodless creature without a balance sheet, without any visible capital structure, without debts, and engaged apparently in the simultaneous purchase of inputs and sale of outputs at constant rates” (1950, p. 34. See also Boulding, 1966, Vol. I, p. 305). Brian Loasby is probably not too wide of the mark when he comments on “the widespread contempt exhibited by economists for accounting (the more scandalous for not being recognized as a scandal)” (1971, p. 882).

The question of risk or uncertainty has not yet been brought explicitly into our analysis. It has so far been incorporated only indirectly or in a proxy fashion. In our discussion of the risk exposure of the debt and equity holders in the firm, for example, we examined the impact on their positions of the degree of financial leverage in the firm's financing structure. But recent advances in the theory of the firm have attempted to handle the question of uncertainty in a more direct fashion. It has generally been assumed that the economic variables entering into the analysis could be interpreted as random variables that are describable by subjectively assigned probability distributions. It is risk in that sense that we shall discuss in this chapter. We shall be concerned with what has been called variability risk, or risk described by the degree of random disturbance in the economic variables that affect the operating results of the firm. An even more fundamental risk, that of the default, bankruptcy, and possible liquidation of the firm, has not been accorded as extensive a treatment.

In focusing on the variability risk, the decision maker has frequently been assumed to choose alternatives on the basis of a utility function defined over the possible profit, economic value, or rate of return that could be generated and the degree of risk involved. The risk, in turn, has been measured by the dispersion parameter of an appropriately defined probability distribution of outcomes.

One of the principal conclusions we reached in Chapter 4 was related to the description of the firm's cost of money capital. We specified there the full marginal costs of debt and equity capital, and these were related to the full marginal cost of relaxing the money capital availability constraint. Equation (4.47) in Chapter 4 instanced an equilibrium or an optimization relation between these full marginal costs. We begin our discussion of the cost of capital in this chapter by considering those concepts further. In doing so, we adopt a quite different analytical stance from that of the preceding equilibrium asset market theory. There we examined the implications of general equilibrium in perfect financial markets. In what follows, we shall be initially concerned with questions of partial equilibrium in conceivably imperfect markets. We shall return to some general equilibrium considerations in later sections of this chapter.

Illustration of the full marginal cost of relaxing the money capital availability constraint

The following example illustrates the empirical meaning of the full marginal cost of increasing the amount of money capital available to the firm by raising an increment of debt capital. It provides an instance of the concept first introduced in Equation (4.31). It will be useful to keep in mind throughout the discussion the fundamental definition of the firm's cost of money capital.

The place of money capital in the theory of the firm is interdependent with the analysis of production, pricing, and capital investment. In this book I have examined those areas of economic theory that bear most directly on that analytical interdependence. In doing so, I have had principally in mind the needs of advanced students, including those who are making an initial approach to the subject at both undergraduate and graduate levels. I hope that my professional colleagues will be interested eavesdroppers, and that in those areas in which some novelty is proposed it might be thought that prospects exist for a meaningful reconstruction and new advances in the theory of the firm.

I have not set out, however, to construct a theory of the firm in its entirety. I have addressed the main issues of the relation between the firm's employment of real capital and money capital, and I have examined the linkage of those questions to the cost and availability of finance and relevant decision making in the firm. My perception of the needs of the student has determined the method and level of exposition. I have found, for example, that students have benefited from a reasonably painstaking exposition of the statistical foundations of probability theory and from a good degree of motivation for the mathematical development of such advanced topics as the utility function defined over stochastic arguments, the equilibrium theory of financial asset prices and yields, the cost of money capital, and investment decision criteria.

Time, uncertainty, and money form an analytical triad that economic theory, if it aspires to realism and relevance, must take seriously into account. The historic, unidirectional flow of time carries with it the inescapable reality of uncertainty and the ignorance in which we are bound. Our analytical constructions that aim to explain the world must confront the influence, the ineluctabilities, with which the passing of time presses on our experience and understanding. Knowledge, it has been said, cannot be gained before its time (Lachmann, 1959, p. 73). Alfred Marshall, the architect of English neoclassical economics, cautioned that “we cannot foresee the future perfectly. The unexpected may happen” (1920, p. 347), and he pointed to the difficulties that arise, as a result, for economic decisions and action. Keynes's observation, when contemplating the impact of the future on economic behavior, that “we simply do not know” (1937, p. 185), recalls his well-known indictment of the classical economics and its attempt to evade the future by a probabilistic reductionism.

Many issues in the theory of the firm are brought into focus by these considerations. Terence Hutchison, whose work has provided luminous perspectives on economic thought, has seen these issues laced together in their interdependence.

The place of money capital in the theory of the firm is interdependent with the analysis of production, pricing, and investment. The preceding chapters of Part II have examined these issues from the perspective of received traditions in the theory. But that analysis, though it has shed considerable light on the financing problem and the specification and usefulness of the cost of money capital, was shackled by the heavy weight of the neoclassical assumptions that it carried. In this chapter we shall look briefly at some of the logical and methodological difficulties inherent in the neoclassical apparatus of thought. Our discussion will not be exhaustive, and it will be designed principally to prepare the way for the alternative perspectives we shall consider in the remaining chapters of this part.

Production and factor employment

Consider first the production problem of the firm. The neoclassical theory proceeds on the assumption that it is possible to specify a production function in such a way that there exists an infinite divisibility of factor inputs and a continuous substitutability between them. The implicit factor relations that exist by virtue of their substitutability are described in terms of the isoquants in the factor input plane. Any such isoquant describes a locus of factor combinations capable of producing a specified level of output. Or more technically, the isoquant describes the set of factor combinations that produce the same output when the factors are combined in their technically most efficient way.

The objective of economic theory, it is frequently suggested, should be that of explaining “human behaviour as a relationship between ends and scarce means which have alternative uses” (Robbins, 1935, p. 16). In this conception of things, the problem of allocation comes sharply into prominence. It has led to the view that economic theory is concerned essentially with the logic of choice. Difficulties inhere in the constriction of economics to such a narrow focus, but it has given rise to extensive investigations into the criteria of choice or action.

Classically, the criterion on the production side of the economy has been that of profit maximization or, as we have seen, the maximization of economic value. On the consumption side, the criterion has generally been the maximization of utility or satisfaction, and a considerable body of theory has developed around the notion of the consumer's utility function. This provides a linkage with our present analysis, pointing to the possibility that decision makers' utility functions may be defined, not only over assumedly known conditions or entities, but over variables whose values can be specified only probabilistically. We raise, therefore, the possibility of what we refer to as the theory of stochastic utility, or of utility functions defined over stochastic arguments. In this chapter we shall examine a number of basic and related propositions that project analogies onto the theory of the firm.

The cost of money capital, understood in one or another of the ways examined in the preceding chapter, serves as a criterion of the economic worthwhileness of investing in the firm. The addition of money capital to the firm, or the retention within it of the money capital that presently exists and may be transferable to other economic uses, may depend, of course, on a number of considerations. Investment may be made in order to protect or increase market shares and in anticipation of economic growth, to effect cost reductions or take advantage of technological change, or to maximize the size of the firm because of the benefits that might thereby accrue to the management. But wisdom dictates, when account is taken of the long-run viability and economic position of the firm, that regard should be paid to the fact that money capital is a scarce resource and that a cost has to be paid for its employment. A balance should be struck between that cost and the economic values or benefits that the employment of money capital can generate.

Investment decision criterion

The basic notations relevant to money capital investment decisions were encountered in Chapter 3. The investment decision requires, in the terms summarized there, that the prospective increment of economic value be no less than the amount of marginal money capital it is proposed to employ.

The concept of income is logically prior to the concept of value. The economic value of an asset depends on the future stream of benefits that the asset will, or is expected to, provide. In the case of an asset, such as we are preponderantly concerned with in the theory of the firm, which is expected to earn a specifiable amount of income or realize a definable cash flow in the future, its economic value is defined as the present value, or the present discounted or capitalized value, of that prospective income stream.

Our purpose in this chapter is to make these concepts related to economic value more precise and thereby lay the foundation for visualizing the determinants of value in more complex cases. In this chapter we shall not give an adequate account of the relevance to the valuation problem of the presence of risk or uncertainty. That important issue must await the subsequent development, in the neoclassical case, of the apparatus of probability and its application to the definition of risk and, in the later postclassical case, the development of the potential surprise analysis.

Economic valuation rests on the proposition that a dollar available today is worth more than a dollar available tomorrow or next year or at some other time in the future. This is not simply a matter of saying that a bird in the hand is worth two in the bush.

An adequate theory of the interdependence between the firm's production, pricing, investment, and financing requires an examination of both its shortrun and long-run behavior. A model of the firm's production decision will not only reflect its selling price consistent with the chosen level of output but will also explain why that price is set at a level adequate to accomplish two objectives. First, net revenues after the deduction of operating costs must be sufficient to provide an acceptable or required rate of return on the money capital invested in the firm. This rate of return must be available after the deduction from revenues of the periodic allocation to a capital asset replacement fund if, in the manner we have emphasized, the firm is to maintain its capital intact. Second, the cash flow generated by the firm will bear a relation to its regular capital investment expenditures. Part of the money capital necessary to finance that investment will be obtained, as a policy decision, from internally generated cash flows. The level at which the firm's selling price is set, as a markup over costs, will therefore need to be large enough to generate those required investable funds. The remaining part of the capital budget will be financed by making new capital issues in the external capital market.

The availability of money capital is brought into relation with the demand for investable funds by the money capital supply-and-demand curves in Figure 11.1.

‘Uncertainty is an intimate dimension of our daily lives. For some, it is the zest of life. Without uncertainty, the distinction between the present and the future is blurred; there are no surprises and no anticipations, hence no thrills; there is no scope for achievement, hence no rewards; and love, which always entails risks as well as the joy of discovery, loses its sharp edge. Yet, for others, uncertainty is the curse of life. It is so for those who feel threatened with loss of life or individual freedom, who have no assured shelter or subsistence, who lack job security and fear unemployment.

‘Uncertainty is thus an intimate dimension of economics as well. Decisions of households, firms or policy makers seldom entail fully deterministic consequences; uncertainty is “generic”. (Still, many titles in economics include the precision “under uncertainty”, not even parenthetical; whereas it should be natural to include the warning “under certainty”, when appropriate.)’

The present book collects twenty papers on economic decisions by households, firms or policy makers. (The title sacrifices to tradition by including the qualification ‘under uncertainty’, not even parenthetical.…) These papers were written over the past 25 years and span my professional career. Yet, there is a common thread running through most of them.

Introduction

Some time ago Stigler (1939) and Hart (1951) made the observation that demand fluctuations are best met by flexible plants, characterised by flat bottomed average cost curves. Actually, if a variety of plant designs are feasible, it may typically be efficient to build plants of different types and to allocate output among them so as to minimise expected total production costs. It is natural to inquire whether a competitive equilibrium will sustain such an efficient solution.

This question has been recently considered by Sheshinski and Drèze (S–D) (1976). In their model, an industry which consists of plants of different designs produces an output, the demand for which is randomly distributed. At each realisation of demand, the price of output is determined competitively so as to equate the output supplied by the firms present in the industry with the given level of demand. Entry and exit of firms is assumed to be governed by expected profits; that is, firms are risk neutral. The equilibrium number of firms is such that no firm in the industry has positive expected profits, and all potential entrants’ expected profits, calculated at the equilibrium price distribution, are non-positive. S–D have analysed the characteristics of the equilibrium distributions of outputs and prices. They have also shown that any competitive equilibrium satisfies the necessary conditions for efficient production – defined as minimisation of the expected cost of meeting the random demand.