Working Paper: NBER ID: w3359
Authors: Bruce C. Greenwald; Joseph E. Stiglitz
Abstract: 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.
Keywords: asymmetric information; theory of the firm; financial constraints; risk behavior
JEL Codes: G32; D82
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial health (G50) | investment behavior (G11) |
| financial strength (G32) | risk premium (G19) |
| risk premium (G19) | R&D investment (O32) |
| temporary demand disturbances (J23) | profitability (L21) |
| profitability (L21) | investment activity (G31) |
| investment activity (G31) | future output (E23) |