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In Economics, what is the Separation Theorem?
The separation theorem is an principle used in economics. It works on the basis that, for the purpose of assessing a market, each business owner is assumed to be aiming to maximize the value of their business. In reality, business owners may have different objectives, such as breaking into new markets or achieving social change. The separation theorem factors out these personal attitudes.
There are three key assumptions in the separation theorem. The first is that a firm makes investment decisions rationally, meaning it isn't being influenced by personal beliefs. The second is that a firm makes its investment decisions in principle without being influenced by the availability of financing: that is to say it decides what needs to be done and then how to pay for it, rather than seeing what money is available and then how to use it. The third key is that a calculation of a project's value doesn't take into account what types of financing are used.
It's important to note that the separation theorem is not designed to be a sensible basis from which individual firms can make decisions. For example, in reality a firm will often reject a capital investment opportunity because it does not seem as good of a value when you take into account the interest payments needed on a loan to finance the opportunity. The theorem is used instead for calculations and theories which apply to an entire market, which require economists to make assumptions about how individual businesses will reach decisions. The theorem gets its name because it aims to separate individual characteristics from the overall behavior of a market.
There are numerous reasons why a company would act differently in reality than if the separation theorem applied in reality. A firm might open offices in a less profitable location because the owner had an emotional attachment to the area. A business owner might reject an option which had the most potential value because of ethical concerns. Each individual business owner will have different attitudes to, and tolerance of, the risks involved in the investment options available to them.
The theorem is commonly referred to as the Fisher separation theorem. This name comes from economist Irving Fisher, who developed the idea. He was best known for his theories on the way that prices could be affected by the amount of money in circulation in an economy rather than merely by inherent demand for and supply of the relevant good or service.
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![Each business owner is assumed to be aiming to maximize the value of their business, according to the separation theorem.]()
By: Rehan QureshiEach business owner is assumed to be aiming to maximize the value of their business, according to the separation theorem.
Discussion Comments
@miriam98 - I believe that the article makes clear that companies do not always act in accordance with the precepts of the theorem, on a case by case basis.
However, in principle I don’t think any business can succeed which doesn’t first forge its vision and then pursue the financing later, as opposed to letting financial resources define the limits of its vision.
Why do I believe that? Because historically, businesses that have a clearly defined vision of how to maximize the value of their business will then be able to sell that vision to prospective lenders.
Bankers are only happy to lend the needed financing when they see you’ve got a plan in place. I don’t think it really pays to think too small, under the illusion that you are simply being frugal.
When I read the article describing how the separation theorem works in practice, I think of the famous movie line, “Build it and they will come.”
In this case of course the “they” does not refer to customers but to finances. The company decides on the best course of action and arrives at the financing later. This is probably an oversimplification but that’s how I see it.
In some industries, however, I think that approach can come back to bite you. I worked in telecommunications and that industry is very infrastructure intensive. The infrastructure was planned and then the company pursued financing.
As most people know, telecommunications went bust for a lot of companies because they simply couldn’t make enough money to continue to service their huge loans.
In short, I believe that the separation theorem is just an idealized expectation of how an industry should behave.
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