This paper summarizes recent developments in the theory of the firm
that have arisen in examining the implications of imperfect information. It
shows that a wide range of these models have similar implications for the
likely reaction of firms to external environmental and policy changes. Two
significant implications are (1) that firms behave as if they are risk
averse individuals maximizing a utility function of terminal wealth
(profitability) -- even when the risks involved are unsystematic -- and (2),
in many circumstances, because this utility function is likely to be
characterized by decreasing absolute risk aversion, firms are likely to
respond significantly (and positively) to changes in cash flow and
profitability. Together these two phenomena are able to account for a wide
range of firm behaviors that have been empirically observed (both formally
and informally) and that are difficult to explain in terms of the
traditional theory of the firm. Furthermore, the responses of such firms to
policy interventions are likely to differ significantly from those of
neoclassical firms.
*Published:
American Economic Review, Volume 80, Number 2, pp. 160-165 (May 1990)
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