The Effects of Product Price Uncertainty on the Owner-Managed Firm: Theory and Evidence

Abstract

In this paper we extend the theory of the owner-managed firm to incorporate product price uncertainty, and we present an empirical test of the model's predictions. Under product price uncertainty, the trade-off between leisure and profit faced by an owner-manager is combined with the trade-off between surety and risk-bearing faced by an entrepreneur. The firm's owner bears the uninsurable and undiversifiable risk about profit caused by product price uncertainty and, as manager, supplies the firm a unique labor factor. The model predicts that the substitution effect of an increase in risk on the quantity supplied by the firm is negative. The income effect of risk reinforces the substitution effect if the entrepreneur's labor supply has a positive wage elasticity, but runs counter to and could dominate the substitution effect if the wage elasticity of labor supply for the entrepreneur is sufficiently negative. Unlike previous research on price uncertainty and the firm, this paper presents an empirical test of the model's predictions. Using data on physicians in solo practice, our empirical analysis indicates that, although wage elasticities of labor supply for the physician-entrepreneurs are negative, greater risk leads to a reduction in output. These results suggest that the substitution effect is dominant in determining the response to product price uncertainty for the owner-managed firms in our sample. Frank Knight [12] gave prominence to the risk-bearing role of the entrepreneur who, as residual claimant, bears the risk associated with a firm's revenue. Tibor Scitovsky [21] later emphasized a different aspect of entrepreneurial activity, the trade-off confronted by an ownermanager between consumption of leisure and pursuit of profit. Both models of the entrepreneur are relevant to predicting the behavior of an owner-managed firm operating in a risky environment. The entrepreneur in such a firm must choose between consuming leisure and supplying labor which provides an uncertain return, the random residual of revenue net of payments to other factors.