Mismatch of Supply and Demand as a Response to Demand Uncertainty

Abstract

We discuss microfoundations for a firm’s choice under uncertainty stemming from sequential macro shocks. Firms are assumed to select the prices and quantity to sell before realization of uncertainty. They maximize their expected profit and solve an optimization problem in the industry with monopolistically competing firms. The discrepancy between the real and expected profits leads to the mismatch between supply and demand. Depending on the realization of the demand, the firm would either not sell the full output in a short term or consumers are going to be rationed. The elasticity of substitution between the products characterizes the short-term mismatch between the supply and the demand: the supply is larger (smaller) than the expected demand when the goods are good (bad) substitutes.