266 THE AMERICAN ECONOMIC REVIEW bution of the return of any share,we shall assume for simplicity that they are at least in agreement as to the expected return.7 This way of characterizing uncertain streams merits brief comment. Notice first that the stream is a stream of profits,not dividends.As will become clear later,as long as management is presumed to be acting in the best interests of the stockholders,retained earnings can be regarded as equivalent to a fully subscribed,pre-emptive issue of common stock. Hence,for present purposes,the division of the stream between cash dividends and retained earnings in any period is a mere detail.Notice also that the uncertainty attaches to the mean value over time of the stream of profits and should not be confused with variability over time of the successive elements of the stream.That variability and uncer- tainty are two totally different concepts should be clear from the fact that the elements of a stream can be variable even though known with certainty.It can be shown,furthermore,that whether the elements of a stream are sure or uncertain,the effect of variability per se on the valua- tion of the stream is at best a second-order one which can safely be neg- lected for our purposes(and indeed most others too).8 The next assumption plays a strategic role in the rest of the analysis. We shall assume that firms can be divided into "equivalent return" classes such that the return on the shares issued by any firm in any given class is proportional to (and hence perfectly correlated with)the return on the shares issued by any other firm in the same class.This assumption implies that the various shares within the same class differ, at most,by a "scale factor."Accordingly,if we adjust for the difference in scale,by taking the ratio of the return to the expected return,the probability distribution of that ratio is identical for all shares in the class.It follows that all relevant properties of a share are uniquely char- acterized by specifying (1)the class to which it belongs and (2)its expected return. The significance of this assumption is that it permits us to classify firms into groups within which the shares of different firms are "homoge- neous,"that is,perfect substitutes for one another.We have,thus,an analogue to the familiar concept of the industry in which it is the com- modity produced by the firms that is taken as homogeneous.To com- plete this analogy with Marshallian price theory,we shall assume in the 7 To deal adequately with refinements such as differences among investors in estimates of expected returns would require extensive discussion of the theory of portfolio selection.Brief references to these and related topics will be made in the succeeding article on the general equilibrium model. 8 The reader may convince himself of this by asking how much he would be willing to rebate to his employer for the privilege of receiving his annual salary in equal monthly installments rather than in irregular amounts over the year.See also J.M.Keynes [10,esp.pp.53-541. This content downloaded from 202.120.21.61 on Thu,30 Nov 201707:07:36 UTC All use subject to http://about.jstor.org/terms266 THE AMERICAN ECONOMIC REVIEW bution of the return of any share, we shall assume for simplicity that they are at least in agreement as to the expected return.7 This way of characterizing uncertain streams merits brief comment. Notice first that the stream is a stream of profits, not dividends. As will become clear later, as long as management is presumed to be acting in the best interests of the stockholders, retained earnings can be regarded as equivalent to a fully subscribed, pre-emptive issue of common stock. Hence, for present purposes, the division of the stream between cash dividends and retained earnings in any period is a mere detail. Notice also that the uncertainty attaches to the mean value over time of the stream of profits and should not be confused with variability over time of the successive elements of the stream. That variability and uncer- tainty are two totally different concepts should be clear from the fact that the elements of a stream can be variable even though known with certainty. It can be shown, furthermore, that whether the elements of a stream are sure or uncertain, the effect of variability per se on the valua- tion of the stream is at best a second-order one which can safely be neg- lected for our purposes (and indeed most others too).8 The next assumption plays a strategic role in the rest of the analysis. We shall assume that firms can be divided into "equivalent return" classes such that the return on the shares issued by any firm in any given class is proportional to (and hence perfectly correlated with) the return on the shares issued by any other firm in the same class. This assumption implies that the various shares within the same class differ, at most, by a "scale factor." Accordingly, if we adjust for the difference in scale, by taking the ratio of the return to the expected return, the probability distribution of that ratio is identical for all shares in the class. It follows that all relevant properties of a share are uniquely char- acterized by specifying (1) the class to which it belongs and (2) its expected return. The significance of this assumption is that it permits us to classify firms into groups within which the shares of different firms are "homoge- neous," that is, perfect substitutes for one another. We have, thus, an analogue to the familiar concept of the industry in which it is the com- modity produced by the firms that is taken as homogeneous. To com- plete this analogy with Marshallian price theory, we shall assume in the 7To deal adequately with refinements such as differences among investors in estimates of expected returns would require extensive discussion of the theory of portfolio selection. Brief references to these and related topics will be made in the succeeding article on the general equilibrium model. 8 The reader may convince himself of this by asking how much he would be willing to rebate to his employer for the privilege of receiving his annual salary in equal monthly installments rather than in irregular amounts over the year. See also J. M. Keynes [10, esp. pp. 53-541. This content downloaded from 202.120.21.61 on Thu, 30 Nov 2017 07:07:36 UTC All use subject to http://about.jstor.org/terms