The technology of risk and return

The behavior of the firm under uncertainty and the valuation of risky assets are basic concerns of contemporary economic and financial theorists. In this study, we present several models which illustrate the interdependence of the micro-economic decisions of the firm and the market's valuation of its capital assets. Such decisions as price and capital investment are shown to affect the risk-return combination presented by the firm to the financial market for valuation. It is assumed that decisions are made in order to maximize the market value of the firm given the riskreturn preferences of investors. Thus, the models we present directly link behavior in the product and financial markets. To represent the financial markets, we make use of the capital asset pricing model (CA PM) developed by William Sharpe, John Lintner, and Jan Mossin. This theory provides, as a condition for capital market equilibrium, an explicit model of the valuation of risky assets. Several advantages over the more familiar expected utility approach result from the use of a positive theory of market value. First, it is desirable that the model of firm decision making under uncertainty be consistent with a financial market equilibrium. Second, the goal of the firm appropriate to financial market theory is the maximization of the market value of the firm. In contrast to the expected utility approach, analysis under the CAPM does not depend on individuals' preference. Third, the use of an explicit model of asset value enables us to derive explicit and computable comparative static results. The resulting implications for firm behavior appear to be suitable for empirical testing and investigation. The prospects for empirical work are further enhanced by the common dependence of all firms on capital marketdetermined parameters. Finally, although the point is not developed in this paper, it should be noted that our approach has the potential to link firms' actions with changes in macro-economic activity. To the extent macro changes affect risk preferences, there will be an impact on, for example, investment decisions. In turn, these have macro implications. We turn to a brief literature review before presenting the basic model and illustrations.