Price Uncertainty and the Exhaustive Firm

Abstract

In an earlier edition of this journal, the risk-neutral exhaustive firm's reactions to various tax-subsidy schemes were explored. Sandmo analyzed the output effects of uncertainty on risk-averse competitive firms and derived comparative statics results dependent on attitudes towards risk, In this paper, we examine the risk-averse exhaustive firm and find: (1) some results are independent of risk aversion assumptions; (2) comparative statics results differ from the no resource constraint case; and (3) results depend on the relative magnitude of the discount rate and fixed costs. It is assumed that capital markets are imperfect, or, alternatively, that if perfect capital markets exist, firms do not have access to them; otherwise risk-aversion would not be operative relative to production decisions as firms would simply extract the resource so as to maximize the discounted present value of profits and then go to the capital market to obtain their desired income stream. This assumption seems to closely approximate real world situations for some resource industries; in particular the coal industry is characterized by a predominance of equity funding, particularly for smaller firms, indicating inaccessibility to capital markets. We find here that even in a simple model, lack of access to perfect capital markets leads to ambiguities and qualitative differences vis-a-vis the risk-neutral firn.