This article shows (1) how entry and exit of firms in a competitive industry affect the valuation of securities and optimal capital structure, and (2) how, given a trade-off between tax advantages and agency costs, a firm will optimally adjust its leverage level after it is set up. We derive simple pricing expressions for corporate debt in which the price elasticity of demand for industry output plays a crucial role. When a firm optimally adjusts its leverage over time, we show that total firm value comprises the value of discounted cash flows assuming fixed capital structure, plus a continuum of options for marginal increases in debt.

In June and July of 1974, the influential Expenditure Committee of the House of Commons heard submissions from economists in the public and private sector on Public Expenditure, Inflation, and the Balance of Payments, House of Commons (1974). The hearings came just few months after the sharp rise in oil prices, and the demise of Conservative government whose incomes policy had made no special allowance for rise in coal miners' income despite the increase in energy prices. The witnesses called to give evidence included prominent British macroeconomists of both Keynesian and Monetarist persuasions; thus, for example, Lord Kahn and David Laidler both spoke before the Committee. The Committee reported, We are told that rise in the of imports was both inflationary and deflationary (para. 23), which they understood to mean price increasing and employment reducing. They also noted that the various witnesses were far from unanimous in what they thought the impact effects would be, and in what they recommended by way of policy. This paper will initially focus on how Keynesians and Monetarists expected the shift in the terms of trade to affect prices and output, and what policy conclusions were derived, using evidence given to the Committee. The main reason for concentrating on this aspect of recent inflation is evident from inspection of Figure 1 which shows how severe was the shock of the rise in import prices over the period 1973-74 (import unit values rose by over 60 percent from 1973-IT to 1974-IT). Later I discuss how the inflationary effects of such an external shock may be amplified by what Sir John Hicks (1975b) has dubbed wage resistance, so that bout of imported inflation may be followed by spell of home-grown inflation. Some witnesses (including those from the Treasury and the National Institute) had referred to the possibility of inflationary pressures from this source (House of Commons, paras. 49, 50, 136, 498). I will argue, however, that neither the Committee nor Hicks gave sufficient attention to the role of the incomes policy in operation when the of oil rose so dramatically. For this policy not only involved confrontation with the coal miners, it also led to the linking of the wages of about one-third of the work force to the retail index, at time when the latter rose sharply because of change in terms of trade. Thus the incomes policy helped to prevent real wages from falling when economic circumstances called for such change. Perhaps it is not surprising, therefore, that the report had very little positive to say about incomes policy, confining itself to expressing the view that a permanent, statutory prices and incomes policy is in modern Britain politically both imprac* London School of Economics and Graduate School of Business, University of Chicago. I would like to thank M. J. Artis, T. Burns, S. G. B. Henry, R. A. Jackman, D. Laidler, D. Sargan, and J. Wise for their comments, without implying that they would accept the views expressed here.

Marcus H. Miller, John E. Spencer; The Static Economic Effects of the UK joining the EEC: A General Equilibrium Approach, The Review of Economic Studies, V

This article shows (1) how entry and exit of firms in a competitive industry affect the valuation of securities and optimal capital structure, and (2) how, given a trade-off between tax advantages and agency costs, a firm will optimally adjust its leverage level after it is set up. We derive simple pricing expressions for corporate debt in which the price elasticity of demand for industry output plays a crucial role. When a firm optimally adjusts its leverage over time, we show that total firm value comprises the value of discounted cash flows assuming fixed capital structure, plus a continuum of options for marginal increases in debt.