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Dynamic Production Theory under No-arbitrage Constraints

Zhao, Guo (2014): Dynamic Production Theory under No-arbitrage Constraints.

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Abstract

I propose a dynamic production model based on the joint constraints of technology, budget and no arbitrage. It is shown that this no-arbitrage based production theory turns out to be a natural generalization of classical production theory based on profit maximization, and confers some methodological advantages over the traditional approach. This no-arbitrage framework for production emphasizes the general equilibrium of the economic system as a whole and constitutes a marriage of production theory and finance, containing the Modigliani-Miller theorem as a consequence. Further, this no-arbitrage based production theory constructs a bridge between microeconomics and macroeconomics, and successfully reconciles some long-standing contradictions arising from the classical theory. For example, it is shown that there does not exist an unconditional trade-off between inflation and output (Lucas 1973; Friedman and Schwartz 1982). This reconciles the long-standing confliction between Keynesian doctrine (Keynes 1936) and the empirical evidence, which was widely regarded as the failure of Keynesian revolution (Lucas and Sargent 1978). Comparative static analysis and dynamic analysis indicate that this model is consistent with the behavior of firms in reality, and can explain a wide range of economic phenomena, including the occurrence of stagflation, Balassa–Samuelson effect and economic growth. Finally, no-arbitrage based production theory gives rise to a new method of calculating the equilibrium exchange rate between any two countries with arbitrary production functions.

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