Price Uncertainty, Utility, and Industry Equilibrium in Pure Competition

Abstract

THE NEOCLASSICAL THEORY of the firm assumes that the entrepreneur behaves as if his demand curve, production function, and factor costs are known with certainty. Although it is recognized that the firm may be uncertain about the form of these functions, the entrepreneur is assumed to compress his judgments about a function into a best estimate. He then behaves as if the best estimate represents the function with certainty. The formal consideration of uncertainty about the functions, however, can significantly qualify the results of neoclassical theory. The purpose of this article is to extend the traditional deterministic model of the firm to the situation in which the price for the firm's product is a random variable. The analysis of this situation is important not only 1Qecause of the generalization of the traditional model, but because it introduces additional considerations, such as attitudes toward risk, that may help to litter explain observed behavior. A number of authors 'have investigated various aspects of the static theory of the firm under demand uncertainty and their major results will be briefly discussed here. Their models can be differentiated by the competitiveness of the economic environment assumed, the nature of the demand uncertainty, and by the behavioral assumptions employed. The models of purely competitive firms will be discussed first and then models of firms in imperfect competition will be considered. Uncertainty is usually introduced into a model of pure competition by assuming that price is uncertain and that the firm can sell any quantity at the price that obtains in the market. Oi [15] assumed that the firm was able to observe price prior to determining output or equivalently that the firm could instantaneously adjust output. With this assumption and an objective of maximizing( expected profit the firm produces such that price and marginal cost are equated as in deterministic theory. Oi was concerned with the desirability of price uncertainty and demonstrated that expected profit exceeds the profit that would be obtained with a certain price which is equal to the expected price. He also demonstrated that the firm prefers increased variability of price in certain cases and extended the analysis to the case of a firm with nonlinear risk preferences.2 Nelson [13] presumed that the firm makes its output decision prior to ob