Determining Capital Structure within Arbitrage-Based Production Framework

To explore the interactions between financial decisions and production decisions of representative firm, we propose a dynamic production model under the joint constraints of technology, budget and no arbitrage. Theoretical and numerical analysis shows that dynamic production in no arbitrage equilibrium may undergo a bifurcation into a stable capital-intensive state and an unstable labor-intensive state. Further, it is shown that in no-arbitrage equilibrium a firm’s capital structure is endogenously determined by its endowment structure. These findings are consistent with empirical evidences and hence justify the no-arbitrage based production model as a useful framework with methodological advantages.