A general theory of the competitive firm under undercertainty

Abstract

The theory of the firm under uncertainty has been subject to an extensive study but, to the best of the author's knowledge, all studies are restricted to the situation in which either the output prices [e.g., Sandmo, 1971, pp. 6893; Batra & Ullah, 1974, pp. 537-48; and Hartman, 1975, pp. 1289-90] or the input prices [e.g., Okuguchi, 1977, pp. 25-30] are random. The purpose of this paper is to examine systematically the optimal behavior of the competitive firm facing uncertainty in both output and input prices. Although the complexity of the model is increased, greater generality is achieved by allowing all the prices to be uncertain. Not only have all previous papers looked at just one type of uncertainty, but also most of their results are derived assuming a decreasing absolute risk aversion utility function [e.g., Okuguchi, 1977, pp. 2530 and Sandmo, 1971, pp. 68-93]. In this paper, however, all the results are obtained under a weaker assumption of non-increasing absolute risk aversion. Moreover, the technique that is used to determine the marginal impact of uncertainty on the firm's behavior may prove useful in other settings as well. In the second part, the overall impact of uncertainty on the optimal behavior of the firm is examined. The third part examines the effect of increased risk on the optimal behavior of the firm. In this part, the impact on the firm's behavior of a mean-preserving increase in risk about the output price and input prices is examined separately. The supply function of the firm, i.e., the firm's output response to a change in the expected price of output, and the effect of a