Dynamic firm behavior under uncertainty

Sergio Lence

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: This study examines and compares the behavior of forward-looking and myopic expected-utility-maximizing competitive firms. The first scenario analyzed is that of a speculative storing firm in the absence of forward markets. It is shown that there are important differences between forward-looking and myopic firms in that the former may store more or less than otherwise identical risk-neutral firms, whereas the latter will always store less than risk-neutral ones. If the forward-looking firm is constant absolute risk averse (CARA) and sufficiently risk averse, at low storage levels it will store more than if it were risk neutral. So long as the firm is CARA, storage is negatively related to current price and the interest rate and is independent from beginning stocks, irrespective of myopic or forward-looking attitudes;The second section introduces forward markets and shows that the speculative storing firm separates storage from hedging. Storage is independent of random variables, risk aversion levels, and forward-looking or myopic attitudes. Under unbiased forward prices, full hedging is optimal for a myopic risk-averse firm but suboptimal for a forward-looking firm. If certain conditions hold, the optimal forward-looking CARA hedge under unbiased forward prices will be less than a full hedge;Next, the model is modified to allow for production without storage. Most of the findings from the speculative storage framework apply to this case if the production function is nonstochastic Leontief, and if output and material input prices are positively related. Under certain conditions, the forward-looking CARA firm will produce more than the risk-neutral one at sufficiently low output levels;The final model considers the most general situation, in which firms are allowed to produce and to store and trade forward both output and material input. The results show that the firm separates "physical" decisions from hedging decisions regardless of forward-looking or myopic attitudes. Physical decisions depend only on current forward and cash prices, the interest rate, and the storage and production cost functions. A model of the soybean-processing sector is developed that supports the hypotheses advanced and shows that forward prices better explain processor behavior than either naive price expectations or perfect foresight.

Date: 1991-01-01
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