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Department of Industrial and Systems Engineering,

National University of Singapore

ABSTRACT

A conceptual model examines the competitive firms optimal input and hedging decisions

under price and output uncertainty. Behavioral utility functions are incorporated to represent the

firms irrational organizational behaviors. The model is then solved in a numerical example

using decision analysis methods. It is shown to be capable to solve for the optimal decisions

under different market conditions and characteristics of the firm. Subsequent sensitivity analyses

suggest that optimal level of hedging is heavily influenced by the futures price and the firms

risk preferences.

1. INTRODUCTION

The uncertain, indeterminable and responsive nature of economic activities leads to the

common existence of risk. Apart from the resource constraints such as capital, labor and

productivity, a producer's output decision is also associated with the risk he is facing and his

attitude towards it. Given a basket of alternatives, risk-savvy producers in the market would

always tend to seek an ideal trade-off point between risk and expected return. In this paper, we

will look into the implications of real-world organizational behaviors in the production decision

problems under both price and output uncertainty.

This paper is organized as followed. In section 2, we present a literature review of existing

production decision models. A typical decision model is introduced in section 3 under expected

utility maximization. The model is then solved in some numerical examples using decision

analysis in section 4 where different behavioral utility functions will also be discussed. Section 5

takes a closer look at the dependency of production decisions on market conditions and risk

preferences by performing several sensitivity analyses. Finally, section 6 concludes with some

suggestions to further study.

2. LITERATURE REVIEW

The majority of existing models of production decision under uncertainty are based on the

expected utility approach. On the optimal level of production, the firm maximizes the

expectation of its utility, which is a function of wealth (or profit). The utility function is

1

normally assumed to be increasing, twice-differentiable and concave to represent the rise-averse

preference of the firm.

In his now well-cited 1971 paper, Sandmo proposed a one-period, single commodity

model to study the competitive firm's output decision under price uncertainty and drew the

conclusion that under price uncertainty, output tends to be smaller than the certainty output. He

also analyzed the effects of change in the expected value and uncertainty of the price on the

optimal output of the competitive firm and demonstrated that the firm's response to an increase

in tax rate is dependent on its relative risk aversion.

The subsequent literature following Sandmo attempted to alter one or few assumptions

made in his model. Batra & Ullah (1974) studied the problem in the long-run, which was further

improved by Paris (1988) who introduced both input and output price uncertainties. Batra &

Ullah (1974) also proved that cost minimization is consistent with the maximizing expected

utility of wealth of a firm facing riskless production but output price uncertainty. Pope and

Chavas (1994) extended this consistency to the case where production is also under uncertainty.

Chavas and Holt (1990) proposed an acreage decision model where producers are able to

distribute his acreage resource (an input factor) among two types of commodities, namely corn

and soybeans, also taking into consideration the wealth effect. The model was used in an

application under government price support programs. Babcock (1990) provided a two-period

model on agricultural production where unused marketing quota (an input factor) can be carried

on to the next period. Lence & Hayes (1998) constructed a model in a multi-period scheme

where firms are able to store its output for sale in the subsequent periods. They concluded that

forward-looking, risk-averse firms will produce more than risk-neutral ones.

Another important aspect of improving the Sandmo model is to involve acquisition of

information and adoption to technology. Information about price and/or technology,

whose acquisition involves certain cost, can be important to the firm's production decision

making. Kihlstrom (1976) was one of the earliest studies on determining the firm's demand for

information, showing that increase in level of information rises expected output, and

a downward-sloping demand curve for that information, which is in consistence with any other

kind of normal goods. Eggert & Tveteras (2004) studied fishers' gear choices (representing a

certain type of production technology).

Saha et al. (1994) suggested that the adoption of technology, also being expensive, can

lead to an increase in the firm's expected output as well as a reduction in its variance (risk). It

turned out that the adoption decision is determined by the expected revenue and cost of the

technology, which is in turn dependent on the amount and completeness of information

available to the producer. The risk factors only influence the optimal level of adoption.

Koundouri et al. (2006) performed a study on adoption of irrigation technology. In their scenario,

technology was treated as a more efficient alternative to the current risky production method.

Adoption of technology thus became a means of hedging against production risk.

2

2.3 The Use of Financial Derivatives

The introduction of financial derivatives has become an influential way for the suppliers

to reduce their risk exposure by selling future products for a certain price. Considerable research

has focused on the topic of production decision under risk with the existence of futures and

forward markets. Holthausen (1979) studied the choice of competitive firm under price

uncertainty in such context. With future markets, the producer has to make both production and

hedging decisions. It is showed that a risk-averse producer's output decision will be the level for

which marginal cost equals the forward price, regardless of their risk expectations or

preferences. However, risk aversion does play a decisive role on the firm's optimal hedging

levels. Grant (1985) further incorporated the possibility of both price and output uncertainty into

the model of risk-averse competitive firm with access to a forward market and his results turned

out to be revolutionary. In the presence of both price and output uncertainty, future markets can

no longer completely remove all the risk, and the producer's decision making is dependent on

many factors such as its risk preference and the correlation between revenue and price. Such

problems are to be solved on a case-by-case basis.

The emergence of options provides producers with more hedging choices. Lapan,

Moschini & Hanson (1991) added options market to the expected utility model. In their model,

firm makes decision on the production scale, and the quantity of futures and options contracts

purchased. Uncertainty exists in end-of-period price while the production function is assumed to

be non-stochastic. They concluded that when futures prices and options premiums are perceived

as unbiased, the optimal hedging decision only involves futures. Otherwise, options shall be

used together with futures. Sakong, Hayes & Hallam (1993) further incorporated production

uncertainty in this model, and showed that producers can partially offset the risk in production

by hedging some of their expected output in the futures market and purchasing put options.

The assumption that the utility function appears to be increasing and concave is

challenged various ways. Kahneman and Tversky (1979) studied loss aversion which takes into

consideration the fact that decision making is partially influenced by current assets. Their

empirical studies revealed the loss aversion function which is convex and increasing below a

certain reference point. Pennings and Smidts (2003) looked into the shape of utility and

organizational behavior. More is discussed in Tverskys book Preference, Belief, and Similarity

(2003).

3

3. THE MODEL

Consider a firm facing a production decision problem at the beginning of the period. It has

to determine the level of input, x, which will produce an output y = fX(x) + e at the end of the

period, where e is a random variable with mean zero. The cost of production can be determined

before the production is made, and expressed as c(x), with dc/dx = c(x) >0. We make the

assumption that the firm is in a competitive market and has no influence on the market price. At

the end of the period, the firm can sell any amount of output it produces at a stochastic price p,

where E[p] =, p = + ep and ep =0. The firm also has access to the forward market in which it

can also choose to sell its output forward at a certain price b at present. Let the amount sold in

the forward market be h. If it turns out in the future that the hedged amount exceeds the real

output, the firm can purchase the difference in the goods market at p and sell in the forward

market in order to complete the forward contract. For simplicity, we assume there is no time

value of money involved in this problem. The firm is to maximize the expectation of the utility

U, defined as a function of profit ,

x ,h p y

Figure 1. Influence diagram for production and hedging decision: price and output uncertainty

4

Under the assumption that U() is increasing, twice-differentiable and concave, that is,

U() > 0 and U() < 0, the first-order to the maximization problem satisfies

E{U '[ pf ' ( x) c' ( x)]} = 0 (2)

respectively.

The problem rises when the utility function does not follow the ideal pattern. Non-linear

programming methods may not be applicable since the concavity assumption is violated. Yet

behavioral utilities have a lot of implications for real world organizational behaviors. The

following section will demonstrate a numerical method to solve the general production decision

problem with the help of decision analysis tools.

4. NUMERICAL EXAMPLES

Programming Language (DPL) software. Solutions are obtained by choosing from different

input and hedging levels to maximize expected utility. The numerical configuration of the

example is presented below.

Input Quantity 26 28 30 32 34 36 38

Mean of

2132 2296 2460 2624 2788 2952 3116

Output Quantity

Stand Deviation of

400 400 400 400 400 400 400

Output Quantity

Cash price at harvest ~ Lognormal (1.50588189, 0.028818849) (it is set such that Mean = 4.51)

Current Futures Price = 4.51 (unbiased)

Futures sold = 800, 1200, 1600, 2000, 2400, 2800, 3200, 3600, 4000

5

4.2 Incorporation of Behavioral Utility Functions

The above model is evaluated using three different kinds of utility functions.

The exponential utility function is the most basic and most commonly used utility function in

uncertainty analysis. It possesses some desired features such as concavity and constant relative

risk aversion (CARA).

In this example, it is defined as

U 1 ( x) = 1 e x / (4)

where the risk tolerance is set to be 6114.6.

U

0.7

0.6

0.5

0.4

0.3

0.2

0.1

x

2000 4000 6000 8000

The piece-wise linear utility is a utility with two linear components kinked at a reference point.

The part below the point has a higher slope than that above it.

(x - 6114.6)/SLOPE_COEF + 6114.6, x > 6114.6

U 2 ( x) = (5)

(x - 6114.6) * SLOPE_COEF + 6114.6, x 6114.6

The slope coefficient is initially set to 2.

U

7000

6000

5000

4000

3000

2000

1000

x

2000 4000 6000 8000

6

4.2.3 Lose-Aversion Utility

The loss-aversion utility also has two parts separated by a reference point. The part above

reference exhibits concavity while the part below is convex.

U

500

400

300

200

100

x

2000 4000 6000 8000

4.3 Results

The decision analysis model is run under three different utility functions. The optimal

decisions are summarized in the table below:

optimal input decision 38 38 38

optimal futures bought 2800 4000 800

Figure 5 shows the risk profile associated with initial decisions in the base case (with

exponential utility function). It shows that input decision of 38 is stochastic dominant over all

the other alternatives:

7

100%

N26

90%

80%

N28

70%

Probability of Exceeding

N30

60%

50%

N32

40%

N34

30%

20%

N36

10%

0% N38

In this example, the firm will choose to pursuit maximum level of production regardless

of its risk preference. However, it is important to note that the firms hedging decisions vary

significantly across different utility functions.

5. DISCUSSION

In order to look into the firms optimal choices in various circumstances, some sensitivity

analyses are performed.

The following graph is obtained by varying current futures price from 4.31 to 4.71 in

steps of 0.02. Judging from the graph, the firm will choose the minimum level of future

contracts (800 units) bought when current futures price is below 4.51 (the round dots), and the

maximum hedging level (4000 units) when the futures price is above it (diamond dots). Only

when the futures price is exactly 4.51 (the unbiased value) will the firm choose to purchase 2800

units of futures contract to partially hedge its output (the square dot).

8

8300

Certain Equivalent

8100

7900

7700

7500

7300

4.31 4.35 4.39 4.43 4.47 4.51 4.55 4.59 4.63 4.67 4.71

current futures price

Next, a two-way sensitivity analysis is performed by varying the slope coefficient and the

input cost rate in the piece-wise linear utility model. Several discoveries are made. First, the

firm will choose maximum input level at all times. Second, when the slope coefficient equals

one, the utility function becomes linear. Risk preference does not play a role anymore and

futures contract does not act as a useful hedging tool. The firm will become indifferent of any

amount of hedging since it is risk neutral. Third, when the slope coefficient is above one,

however, the firms optimal hedging decision solely depends on the input cost rate. It will

choose to fully hedge when the cost per unit of input is below 132 or above 156, but will have to

make various level of partial hedging decisions when the input cost rate is within the region.

Finally, as long as the slope coefficient is above one, optimal production and hedging decisions

will be independent of its value.

1.9

1.8

1.7

1.6

slope coefficient

1.5

1.4

1.3

1.2

1.1

1

120 126 132 138 144 150 156 162 168 174 180

input cost rate

9

6. CONCLUSION AND FUTURE WORK

agricultural and financial industries. This paper has demonstrated a generalized model and a

decision analysis solution. It has taken into various aspects of the problem including price and

output uncertainties, the use of forward contracts as hedging tools, and behavioral utility

functions.

Hedging is a powerful tool to reduce the risk that the producer is facing. This paper

discusses the firms optimal hedging decisions under differences circumstances. According to

the efficient-market hypothesis, the futures price is an unbiased estimate of the goods market

cash price in the future. Therefore, the firms optimal hedging decision would be to partially

hedge its output to maximize the expected utility. The model is capable of solving for the

optimal decision given the sufficient market conditions.

In this study, organizational behavior in the form of behavior utilities is also incorporated

together with the traditional exponential utility. All the three utilities functions are important,

because empirical studies have already suggested that not all organizations are rational and

behave in consistent with the risk-aversion assumption. This paper has similar findings

compared to the traditional expected utility approach that the firms hedging decisions is

strongly dependent on its risk preferences.

A limitation to the example is that the cost function is linear based on the competitive firm

assumption. This leads to a smaller overall marginal cost than marginal revenue. This is the

reason behind the firms decision to maximize input. A more exhaustive study will need to look

in to the economies and/or diseconomies of scale by using a different cost function.

Nevertheless, the decision analysis model needs not to be changed.

One possible extension to the model is to put the production decision problem in a

monopoly or oligopoly context. The influence of the firms size on market demand, together

with the relationship between quantities and market price, need to be recognized. Under the new

framework, the uncertainties in the market demand curve need be further specified to replace the

competitive market assumption based on which the firm can sell any amount of output at a given

price in order to make a more coherent representation of the market condition.

REFERENCES

Babcock B. A. (1990), Acreage Decisions Under Marketing Quotas and Yield Uncertainty,

American Journal of Agricultural Economics, Vol. 72, No. 4, pp. 958-965.

Batra. R. N., and A. Ullah (1974), Competitive Firm and the Theory of Input Demand Under

Price Uncertainty, Journal of Political Economy, LXXXII, pp. 537-548

Chambers R. G., and Quiggin J. (1998), Cost Functions and Duality for Stochastic

Technologies, American Journal of Agricultural Economics, Vol. 80, No. 2, pp. 288-295

Chavas Jean-Paul and Holt M. T. (1996), Economic Behavior under Uncertainty: a Joint

Analysis of Risk Preferences and Technology, The Review of Economics and Statistics, Vol.

78, No. 2, pp. 329-335.

Chavas Jean-Paul, and Holt M. T. (1990), Acreage Decisions Under Risk: The Case of Corn and

10

Soybeans, American Journal of Agricultural Economics, Vol. 72, No. 3, pp. 529-538.

Eggert H. and Tveteras R. (2004), Stochastic Production and Heterogeneous Risk Preferences:

Commercial Fishers Gear Choices, American Journal of Agricultural Economics, Vol.

86(1) (February 2004): 199212

Grant D. (1985), Theory of the Firm with Joint Price and Output Risk and a Forward Market,

American Journal of Agricultural Economics, Vol. 67, No. 3, pp. 630-635.

Holthausen D. M. (1979), Hedging and the Competitive Firm under Price Uncertainty, The

American Economic Review, Vol. 69, No. 5, pp. 989-995.

Katz E. (1984), THE FIRM AND PRICE HEDGING IN AN IMPERFECT MARKET,

International Economic Review, Vol. 25, No. 1 , pp. 215-219

Kahneman D., and Tversky A., (1979), Prospect Theory: An Analysis of Decision under Risk,

Econometrica, Vol. 47, No. 2, pp. 263-292.

Kihlstrom R. E. (1976), Firm Demand for Information about Price and Technology, The Journal

of Political Economy, Vol. 84, No. 6, pp. 1335-1341.

Koundouri P., Nauges C., and Tzouvelekas V. (2006), Technology Adoption under Production

Uncertainty: Theory and Application to Irrigation Technology, American Journal of

Agricultural Economics, Vol. 88(3), 657670

Lapan H., Moschini G., and Hanson Steven D. (1991), Production, Hedging, and Speculative

Decisions with Options and Futures Markets, American Journal of Agricultural Economics,

Vol. 73, No. 1, pp. 66-74.

Lence S. H. and Hayes D. J. (1998), The Forward-Looking Competitive Firm under Uncertainty,

American Journal of Agricultural Economics, Vol. 80, No. 2, pp. 303-312

Paris Q. (1988), Long-Run Comparative Statics under Output and Land Price Uncertainty,

American Journal of Agricultural Economics, Vol. 70, No. 1, pp. 133-141

Pennings J.M.E., and Smidts A., (2003), The Shape of Utility Functions and Organizational

Behavior, Management Science, Vol. 49, No. 9, pp. 1251-1263

Pope R. D., and Chavas Jean-Paul (1994), Cost Functions under Production Uncertainty,

American Journal of Agricultural Economics, Vol. 76, No. 2, pp. 196-204

Saha A., Love H. A., and Schwart R. (1994), Adoption of Emerging Technologies under Output

Uncertainty, American Journal of Agricultural Economics, Vol. 76, No. 4, pp. 836-846

Sakong Y., Hayes D. J., and Hallam A. (1993), Hedging Production Risk with Options,

American Journal of Agricultural Economics, Vol. 75, No. 2, pp. 408-415

Sandmo A., (1971), On the Theory of the Competitive Firm under Uncertainty, American

Economic Review, LXI, pp. 65-73

Tversky A., (2003), Preference, Belief, and Similarity: Selected Writings, The MIT Press

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