Production Flexibility, Price Uncertainty and the Behavior of the Competitive Firm

Abstract

THE PAST FEW YEARS HAVE WITNESSED important advances in the theory of the firm under price uncertainty, with increasing attention being devoted to the question of how a firm's decisions are affected by its attitude towards risk taking.' Specifically, recent work by McCall [7] and Sandmo [15] has established that a competitive firm's output under uncertainty will be smaller, larger, or the same as it would be under certainty, depending upon whether it is risk averse, risk attracted or risk neutral, respectively.3 Leland [6] has shown that, with the addition of a mild restriction on the stochastic demand function, these results obtained under quite general conditions by Sandmo, extend to the case of a quantity setting monopolist as well.4 He also analyzes the same question for the price setting monopolist and indicates some additional complications that arise in that case. Practically the entire literature on the subject makes the assumption (either implicitly or explicitly) that the firm is required to make all its production decisions for a given period before the selling price for that period is known and that once these decisions are made, they are irrevocable.5 Demand and sales are then determined after the market price has been established. In other words, the firm has no flexibility in its production decisions and this is a rather restrictive assumption. The purpose of this paper is to develop a one period model of the competitive firm relaxing this assumption and to determine how a firm having production flexibilities responds to uncertainty. The firm being considered here makes its production decisions on the basis of stochastic information about the selling price of its product, but possesses the ability to modify these plans-at additional cost-after it learns the true selling price. Hence the

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