Hedging and the Competitive Firm under Price Uncertainty

Abstract

Recent models of the competitive firm under uncertainty have explored ways in which the competitive firm's decisions would deviate from those of a firm operating with certainty and have explored the effects of increasing risk aversion on the firm's decisions (see, for example, Agnar Sandmo; David Baron; Hayne Leland; R. N. Batra and Aman Ullah; and the author). These models all assume that the firm's only response to uncertainty is to adjust its output or input levels. In practice, however, a number of institutions have been developed to aid firms in the management of risk. One of the most common methods used to deal with price uncertainty is hedging. Futures markets exist for many agricultural products and some metals. Firms may also use forward contracts to fix the price at which output or inputs are traded in the future. Although there is a large literature dealing with futures markets, few attempts have been made to incorporate futures or forward trading in the theory of the firm.' Such a model is developed in this paper. A risk-averse, competitive firm is assumed to face price uncertainty. It must choose its level of output before the price uncertainty is resolved and may, at the same time, buy or sell output in a forward market at a fixed price. The major result of the paper is that the firm will produce a level of output which depends only on the forward price and is, in particular, independent of the firm's degree of risk aversion and the probability distribution of the uncertain price. In addition, if the forward price is less than the expected future price, the firm will generally hedge some, but not all, output in the forward market; it will hedge more, the more risk averse it is; and it will hedge more as the riskiness of the uncertain price increases. Finally, the existence of a forward market will generally induce the firm to produce a greater output than it would have in the absence of such a market.

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