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The Firm’s Perception of Demand Shocks and the Expected Profitability of Capital under Uncertainty

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  • Pedro Rui Mazeda Gil

    ()
    (Faculdade de Economia, Universidade do Porto)

Abstract

This paper revisits the results of the pioneering models of the firm under demand uncertainty and analyses the apparent disparity with respect to the signal of the investment-uncertainty relationship predicted by them. In the 1970’s-1980’s the modelling of demand uncertainty at the firm level taking into account the firm’s optimal choice of factor inputs constituted a cutting-edge research topic. But while setting the standards in the literature of the firm’s optimal behaviour under uncertainty, those models did not clarify the rationale behind the disparity of the results concerning the impact of increased uncertainty on the firm’s desired investment. In the context of an isoelastic stochastic demand function, where the shock variable may enter either linearly or non-linearly, we show it is the way the firm perceives the demand shocks that, by determining the shape of the profit function, establishes the signal of the investment-uncertainty relationship predicted by the model.

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Bibliographic Info

Paper provided by Universidade do Porto, Faculdade de Economia do Porto in its series FEP Working Papers with number 195.

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Length: 22 pages
Date of creation: Dec 2005
Date of revision:
Handle: RePEc:por:fepwps:195

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Keywords: Demand Uncertainty; Expected Profitability; Shock Perception; Jensen’s Inequality.;

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  1. Andrew B. Abel & Janice C. Eberly, 1995. "The Effects of Irreversibility and Uncertainty on Capital Accumulation," NBER Working Papers 5363, National Bureau of Economic Research, Inc.
  2. Smith, Kenneth R., 1969. "The effect of uncertainty on monopoly price, capital stock and utilization of capital," Journal of Economic Theory, Elsevier, vol. 1(1), pages 48-59, June.
  3. Abel, Andrew B & Eberly, Janice C, 1994. "A Unified Model of Investment under Uncertainty," American Economic Review, American Economic Association, vol. 84(5), pages 1369-84, December.
  4. Rothschild, Michael & Stiglitz, Joseph E., 1971. "Increasing risk II: Its economic consequences," Journal of Economic Theory, Elsevier, vol. 3(1), pages 66-84, March.
  5. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
  6. Smith, Kenneth R, 1970. "Risk and the Optimal Utilization of Capital," Review of Economic Studies, Wiley Blackwell, vol. 37(2), pages 253-59, April.
  7. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  8. Leland, Hayne E, 1972. "Theory of the Firm Facing Uncertain Demand," American Economic Review, American Economic Association, vol. 62(3), pages 278-91, June.
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