The Firm Under Uncertainty: Theoretical Development and Empirical Tests

Abstract

Our paper models and empirically tests the production behavior of firms operating under uncertainty. The study compares firms operating in perfect competition with those producing with product market power. Our model predicts that both types of companies produce less under uncertainty from the cost of risk. In addition, our model predicts that companies with market power have a greater market value, face more product market uncertainty, use less leverage but have similar levels of default risk as firms operating under perfect competition. We empirically test our model by comparing manufacturing firms that operate in close to perfect market competition having little product differentiation and operating in low concentrated industries versus those that have product market power using advertising and/or R&D and operating in highly concentrated industries. The empirical evidence supports our hypotheses. We also model and empirically investigate the effect of the option against value on the firm's performance that occurs to companies when the real product market changes greatly reduce or even eliminates firms' product markets. Long, Wang and Zhang (2006) originally presented this idea and tested it with the machine tool industry to investigate dynamic downward changes in real product markets and the resulting affect on individual firms' values. We also find that smaller companies, those with less capital market following are more likely to experience a product market shift going out of business. This is even after we controlled the default probability estimates based on Merton's Equity Option Pricing.