Technological Uncertainty and the Theory of the Firm

Abstract

Several recent articles [1; 6] have generalized the theory of the firm to incorporate price uncertainty and risk aversion. It is now well known that the risk averse entrepreneur will select that level of output at which the expected price equals the marginal cost plus the marginal risk premium. Leland [5] provides a similar generalization given demand uncertainty. However, in each case the assumption of a well-specified technology is maintained. This paper complements and generalizes the earlier work on the theory of the firm by investigating the effect which technological uncertainty has on the firm's optimal production decision. Like the earlier work on the theory of the firm, we show that the firm selects the level of input at which the expected marginal productivity equals the factor price plus the marginal risk premium. Unlike the earlier work, we show that the sign of the marginal risk premium is not always positive and that it depends on the structure of the firm's technology.' We show that the distinction between price and technological uncertainty is important because each can lead to different implications for firm behavior. Like its predecessors, the model of the firm presented here assumes a single ownerentrepreneur who makes the production decision. We modify the Baron and Sandmo models by assuming that the entrepreneur knows the cost of each production decision but not the output. As a result the entrepreneur's decision yields a random variable denoting output and a linear transformation of it denoting profit. The entrepreneur chooses the random variable denoting profit to maximize his expected utility. There are at least three distinct, ways in which our notion of technological uncertainty may be interpreted. First, the entrepreneur may not know the location of the production surface. In this case each production decision yields a random output; an increase in the