Estimation of Moments and Production Decisions Under Uncertainty

Author(s): Elie Appelbaum and Aman Ullah

Source: The Review of Economics and Statistics, Vol. 79, No. 4 (Nov., 1997), pp. 631-637
Published by: The MIT Press
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 ESTIMATION OF MOMENTS AND PRODUCTION DECISIONS
UNDER UNCERTAINTY
Elie AppelbaumandAman Ullah*

Abstract-The purpose of this paper is to examine production decisions II. Theoretical Framework
under output price uncertainty. Using a nonparametric estimation tech-
nique to estimate the first four moments of the unknown price distribution
Consider a competitive firm whose technology is given by
and applying duality, we provide a simple empirical framework for the
the production function y = F(x), where y is output, x is a
analysis of supply and demand decisions under price uncertainty. The
vector of inputs, and F is a continuous, nondecreasing
model is used to examine the importance of higher moments in the firm's
production decisions and to investigate underlying attitudes toward risk.
quasi-concave production function. We assume that when
the firm makes its decisions, it knows the input price vector
I. Introduction w, but does not know the output price p. The price of y is
r HERE exists a vast theoretical literatureon the effects of distributed according to the (cumulative) distribution func-
= U2. It is useful to define
- uncertaintyon firm behavior.The most common assump- tion G, with E(p) p and Var((p)
=
the price as p = p + e-p +
?E, where E and e= oEare
tion in the literatureis that firms maximize a von Neumann-
Morgenstern utility function.' Hence, for example, if the random variables whose distribution functions are Ge and
price of output is unknown, the whole price distribution GE with E(e) = E(E) = 0 and Var(e) = ca2.
plays a role in the firm's decisions. Consequently, all We assume that the firm maximizes expected utility of
moments of the price distribution could be important in profits, E[U(IT)] = E{U[py - wx - r]}, where uTis profit, r
production decisions. There are also numerous studies that is a fixed cost,4 and U is a von Neumann-Morgenstern utility
use a mean-variance framework, where only the first two function with U' > 0. The solution to the firm's problem
moments of the distribution play a role.2 Unfortunately, defines the (dual) indirect (expected) utility function V as
while the theoretical literature on production under uncer-
max EjU[(p +? E)y- wx - r]: y ? F(x)}
tainty is vast, there are very few empirical studies applying
(1)
these models.3 In particular,given the difficulties in obtain-
-V(W, p-,r, , p)
ing estimates of varying higher moments, the importance of
higher moments has not been examined empirically. where p represents higher moments of G, and V is continu-
The purpose of this paper is to examine production ous and convex in the moments.5 The firm's demand and
decisions under output price uncertainty. Using a nonpara- supply functions can be easily obtained from the indirect
metric estimation technique to estimate the first four mo- expected utility function V. Applying the envelop theorem to
ments of the price distribution and applying duality, we equation (1) we get
provide a simple empirical framework for the analysis of the
effects of uncertainty on production decisions. The model is av
used to examine the importance of higher moments in -E[U'U())]x(
- (2)
production decisions and to study underlying attitudes
toward risk.
Applying the model to the U.S. printing and publishing
a
-= yE[U'(Tr)] (3)
and the stone, clay, and glass industries, we find that higher
moments play a significant role in determining input and
output decisions. Specifically, we test for and reject risk dv
neutrality. We find that, for both industries, production E[U'(r)] (4)
ar -
responses indicate the existence of risk aversion and are
consistent with behavior under decreasing absolute risk so that the firm's input demand and output supply functions
aversion. are given by6

Received for publication July 25, 1994. Revision accepted for publica-
av jay
Xi =- X 5)
tion June 4, 1996. dwi dr
* York University, Toronto, and University of California at Riverside,
respectively.
Financial support from SSHRCC is gratefully acknowledged. We wish to
thank the referees for their useful comments and suggestions. y= - _ / (6)
I See for example, Sandmo (1971), Batra and Ullah (1974), Appelbaum dp5 r
and Katz (1986), and Dalal (1990). For additional references see Hey
(1979). 4 The inclusion of fixed costs is, essentially, for convenience. The same
2 More recently non-expected utility models have also been applied to results can be obtained (slightly differently) when r = 0.
production under uncertainty.See Chew and Epstein (1992). 5 Proofs are given in Appelbaum (1993) and can be obtained from the
3 For examples of empirical studies that consider the effects of uncer- authors upon request.
tainty on firm behavior see Parkin (1970), Just (1974), Antonovitz and Roe 6 See, for example, Pope (1980), Chavas (1985), Chavas and Pope
(1986), Appelbaum (1991, 1993), and Appelbaum and Kohli (1993). (1985), and Dalal (1990).

? 1997 by the Presidentand Fellows of HarvardCollege and the MassachusettsInstituteof Technology [ 631 ]
632 THE REVIEW OF ECONOMICSAND STATISTICS

where xi and wi are the ith elements of x and w, respectively. 6. (a) Input demand functions are symmetric (axil
Equations (5) and (6) are the equivalents of Roy's identity in awj = axjlawi) (for any utility or density function) if
consumer theory. and only if V is weakly separable in input prices.
Without uncertainty, additional properties of dual func- (b) Demand and supply are reciprocally symmetric
tions can be easily obtained, since either the objective (aylawj = axj?a)) if and only if V is weakly separable
function (in the theory of the firm) or the constraint (in the in input prices and expected output price.8
theory of the consumer) is linear. Specifically, dual functions
usually also satisfy homogeneity and monotonicity restric- III. Empirical Implementation
tions (see Diewert (1982) and Epstein (1981)). These
restrictions are used to obtain qualitative results to test the A. EconometricSpecification
underlying theory and to reduce the number of parameters Having discussed the theoretical framework, we now
that need to be estimated in empirical applications. provide examples of empirical applications. To implement
Since profits are transformed nonlinearly by the utility the model empirically, we first have to specify a functional
function, similar properties do not necessarily hold for the form for the indirect expected utility function. Given this
indirect utility function V. Specifically, under output price functional form, if the moments of G were known, we could
uncertainty, demand and supply functions are not necessar- simply estimate the system of equations (5) and (6).
ily homogeneous, symmetric, and downward (upward) slop- Unfortunately the moments of the distribution G are gener-
ing. Appelbaum (1993) shows that the indirect utility ally not known and will, therefore, have to be estimated. For
function V satisfies the following properties: example, assuming rational expectations, the firm forms its
expectationsof the moments of G by estimatingthe demand
1. V is nonincreasing in input prices and fixed cost, but function,using marketinformationon variablesthat determine
nondecreasing in expected output price. demand.Given estimatesof the moments of the price distribu-
2. V is decreasing, increasing, or constant in a if the firm tion, we can estimate the firm's demand and supply functions.
is risk averse, risk loving, or risk neutral, respectively. The model can then be used to test regularityconditions and
3. If changes in a or r affect demand and supply, the firm hypothesesregardingattitudestowardrisk.It can also be used to
cannot be risk neutral. estimatethe effects of uncertaintyand the importanceof various
4. V is not homogeneous of degree 1 in p5,w, r, or in p, w, moments in determining the firm's production decisions.
r, a. Risk neutrality is a necessary and sufficient The examples we provide apply the model to the U.S.
condition for linear homogeneity of V. Linear homoge- printing and publishing (PP) and the stone, clay, and glass
neity of V in p, w, r (risk neutrality) is a necessary and (SCG) industries. These industries were chosen simply as
sufficient condition for demand and supply functions examples of possible applications of our model, but also
to be homogeneous of degree 0 in p3,w, r. since they are considered competitive.9 We also applied the
5. The Slutsky equation (equivalent to the one in con- model to the U.S. paper and allied products, furniture and
sumer theory) is given by fixtures, and the textile industries. We do not report results
for these industries since they were similar.
axi axi axi We assumethatthereare threecompetitivelypricedinputsin
w1- WjdV -x (7) the productionprocess-labor xl, capital Xk, and intermediate
goods (materials)xm-whose prices are wl, Wk,and wm, respec-
where(3xiawj)|dV=O - Si is the compensatedsubstitu- tively.The dataarefor the period1948-1989. This is the updated
tion effect (holding V constant). The [Si] matrix is data set from Jorgensonet al. (1987), where a discussionof the
symmetric negative semidefinite. However, as can be data constructioncan be found. To ensure that the results are
seen from equation (7), this does not imply that the independentof unitsof measurement,all pricesin the paperwere
[axilawj] matrix is also negative semidefinite. Thus normalizedandmeasuredin real,ratherthannominal,terms.10
input demand functions are not necessarily downward To conform with the analysis above, where a fixed cost
sloping.7 Similarly, we define was used, we break problem (1) into two steps. First, we
define the restricted indirect expected utility function J as
ay _= ay
_ dv=o ay ar Y the solution to the problem,
(8)
PdV=O ar
maxy xl x E{U[(p + UE)y - WIXI- WMX - r]
wherethe compensatedsupplyeffect SP= (&YIP) dV=O is (9)
positive. But again, this does not imply that the supply :y F(xl, Xm, Xk)}=J(w1, Wm,p, r, Xk,tY, p)
function is upward sloping.
8 Which implies that technology must satisfy constant returnsto scale.
9 See Appelbaum (1982).
7 This corresponds to the standard result in consumer theory, where 10As an alternative, we also used the aggregate price index (from
Marshallian demand functions are not necessarily downward sloping, but Jorgenson et al. (1987)) to calculate real prices. This yielded similar results
compensated demands always are. as far as the elasticities and test results are concerned.
 UCTIONDECISIONS UNDER UNCERTAINTY 633

where r = wkxk.The solution to problem (1), V, is then given p+ -yilnwi +E lj3ln gj

by l J
+ Ilk ln xk + ,lr ln r
-
WMi, p, r, Xk, a, p): r = WkxkI -Sy (13)
maxxk {J(w1, Pr + Otirlnwi + 'jrIn ,j
(10)
--V(w, o,
+ frk Inxk + rr In r
p, P).

In the empirical analysis we work with the restricted

function,11and we use the first four momentsof the price where si = wixilr for i = 1, m and sy = pylr -tlyIr are the
distribution, jsl, ..., p4. From a theoretical viewpoint it input and output "shares."Since the system of equations
seems ratherunlikelythathigherordermomentswill play a (12) and (13) is homogeneous of degree zero in the
rolein the firm'sdecisions.In fact,theredo not seem to exist parameterswe use the normalization
theoreticalresults in the literatureon productiontheory
underuncertainty,which dependon higherordermoments. 13r - 1. (14)
Thuswe assumethatthe restrictedindirectexpectedutility
functionis given by the translogfunction Forempiricalimplementation the modelhas to be imbed-
ded within a stochasticframework.To do this we assume
thatequations(12) and (13) are stochasticdue to "errorsin
ln J = aoo+ oai ln wi + 0.5 I a'oihln wi ln Wh optimization."Wedefinethe optimizationerrorsin the share
i i h
equations at time t as vy(t), vl(t), and vm(t).We denote the
column vector of disturbances at time t as v(t) {vy(t),
+ j ,j + 0.5 z
311n ln ,ljIn g
j,Bg vj (t), vm(t)land assume that the vector of disturbancesis
I I g
identically and independently,joint normally distributed
' with meanzero andnonsingularcovariancematrixfl,
+ a ikln wi Inxk + yYijnwi ln Sl1
i iij
Qf, foralls, tifs =t
+ f31k ln1I lnxk + ,kln xk (11) E[v(s)v(t)] = O, if t 0 s
(15)

wherefl is a 3 X 3 positivedefinitematrix.
+ 0.513kk(lnXk)2
B. EmpiricalResults
+ Oairln wi ln r + Bjrln j ln r First we estimatethe momentsof the price distribution.
i J
We assumethatthe demandfunctionis given by
+ Pr ln r + 3rkln Xkln r + 0.5,13rr(ln
r)2,
p = D(z) + e (16)
i,h =l,m, j,g = 1,... .,4
where the variablesin the vector z are taken as aggregate
the U.S. aggregateoutputand price
withthe symmetryrestrictionstih = aXhi,ljg = fg3,and yij = outputof the industry,
indexes(also takenfrom Jorgensonet al. (1987)), anda time
yji.ApplyingRoy's identityto equation(11) we get the input the conditional(on z) firstfourmoments
trend.
We estimate
demandand outputsupply "share"equations(correspond-
of p nonparametricallyas follows. Consider the scalar
ing to equations(5) and(6)) as
random variablep and the 1 X q random vector z =
[Zi, . . ., Zq]. Then the rth-order conditional moment of p
aci+ tih ln Wh + 'YijIn pj given z is mr(Z)= E(prIz) for r = 1, 2, .... For r = 1,
h i
ml(z) E(plz) is the conditionalmean of p; for r = 2,
+ aik ln Xk+ ai, ln r
=
m2(Z) = E(p21z) is the second conditional moment of p
Si
S r +? aOirlnwi ? + jr lnijl (12) given z; and so on. The problemwe considerhere is the
i I nonparametric kernelestimationof mr(z)based on the data
+ rk ln Xk + Irrln r {pi, zi}, i = 1, . . ., n. For r = 1, the well-known Nadaraya
h, i = 1,m, j = 1, ... , 4 (1964) andWatson(1964) kernelestimatoris

n
11But,of course,this does not meanthatwe takexkas fixed.All it means m. (z) = piwi(z) (17)
is thatthe solutionis conditionalon the changingvaluesof Xk. i=l1
634 THE REVIEW OF ECONOMICSAND STATISTICS

where ization and symmetry restrictions imposed. The parameter

IZi Z\ I Ii Z estimates, we check for local regularity restrictions (at the
wi(z) = K h )/ K h
and K(.) is the kernel function and h the window width or
smoothing parameter.The kernel K(-) has the properties that
it is nonzero, integrates to unity, and is symmetric, such as a
multivariatenormal density with a zero mean and an identity
covariance matrix.
Intuitively, the estimator m4l(z) is the weighted average of
the pi values corresponding to those zi's which are around z,
the point at which mlhis calculated. The weights are given by
the kernel function K(.), which is usually chosen to be a
symmetric density aroundzero and is such that it gives a low
weight to these observations zi that lie far from z. It is well
known that the choice of kernel does not seem to matter a
great deal (see, for example, Ullah (1988, p. 643)). Here we
use the product of normal kernels K(z) = HlflI K(zj), where
K(zj) is a standardnormal density. The window width h is an
importantparameter,and its choice determines the "size" or
the interval around z over which the observations are
averaged. Usually the larger the h is, the less is the variance
and the smoother the curve, but the largerthe bias. The h that
minimizes the asymptotic integrated mean-squared error of
m is of nl/(4q) In our calculations we take h = n-l (4+q) and
use the [zil,... , Ziq]data scaled with their standard devia-
tions. For details on the choice of kernel K and window
width h see Marron (1988) and Ullah (1988).
We note that mil(z) is the sample estimate of the popula-
tion average of p-values conditional on z, E(p z). Therefore
one can write the nonparametric estimators of mr(z), the
average ofpr conditional on z, as
estimates are given in table 1. Given these parameter
(18) point of approximation). Local monotonicity requires that
oti< 0, otr< 0, and PI > 0. The parameterestimates in table
1 show that these condition are satisfied. We calculated Si
and SP at the point of approximation, and found them to be
negative definite and positive definite, respectively, for both
industries. Checking for convexity of V in the first moment
of the distribution, we found it to be satisfied locally.12 We
tested and rejected linear homogeneity of V in pj,r, wi, wmfor
both industries, which implies that we must reject risk
neutrality.Finally, we test for the symmetry of input demand
functions (the weak separability restrictions). The local
restrictions for weak separability of V in input prices are
given by the restrictions13
a/l Yij (lr
=-Yin1= c m j= 1, ...,4. (23)
OLM 'Ymj ?tmr
We test for and reject these restrictions (which implies that
also global weak separability is rejected). Since weak
separability in input prices is a weaker restriction than weak
separability in input and expected output prices, the rejec-
tion of conditions (23) implies that reciprocal symmetry of
supply and demand functions is also rejected.
To examine the effects of the exogenous variables on the
firm's production decisions, we use the parameterestimates
to calculate the corresponding elasticities. First, demand and
supply elasticities with respect to the moments of the price
distribution are given by
1i-YijlA PJr,a for i = , m, j = 1, . . . ' 4 (24)

n and
MrI(Z) = Epwi (z) (19)
i=l 3lj/81PJirg j = 2,3, 4
oyj P1/81 3lIrb - 1, j = 1 (25)
where wi(z) is as in equation (18). Using this result we can
write the nonparametric estimator of the rth conditional
where
moments aroundthe mean as
alnJ alnJ alnJ
P2(PIz)= m2(z)-m 2(z) (20) _ ,i ',8
=lI,m, 81 , d-r
a Inwi' a In pl a In r'
P3(p|Z) = m3(Z)- 3 h2(Z)4 z(z) + 2m13(Z) (21)
Supply and demand are unaffected by the higher moments,
I2, P3, p4, if and only if the corresponding elasticities satisfy:
(PIZ) = i4(z) - 4 z3(Z) h1(Z)
Oij= Oyj= 0 for all i = 1, m andj = 2, 3, 4. The local
(22)
+ 6fi2(z)m2l(z)- 3 4(z).
12
Since all of the parameters (in equation (11)) which do not involve
input prices or VIudo not appear in the estimated equations (12) and (13),
The asymptotic properties of Mir(z) are well established in we cannot check for convexity in the higher moments.
the literature.(See, for example, Singh and Tracy (1977)). 13
Note that since VilVj = Cl/Cj (as can be seen in footnote 15), input
Given the nonparametric estimates of the first four prices also have to be weakly separable in all moments. They do not have
to be weakly separable, however, in Xk, that is, we can have C(w, y, Xk) =
moments of p, we estimate equations (12) and (13) for the C(h(w, Xk), y, Xk). Thus the local restrictions include all parameters that
two industries using maximum likelihood with the normal- involve r and the moments, but not necessarily those that involve xk.
 PRODUCTIONDECISIONS UNDER UNCERTAINTY 635

TABLE 1.-PARAMETER ESTIMATES AND CORRESPONDING t-VALUES OF V

Parameter PP SCG Parameter PP SCG

Prk 1.95964 0.086472 atm -1.02026 -1.1262

4.43135 0.254489 -65.0617 -28.2099

Pir 0.22142 0.2443 Oamk 0.622997 0.38573

2.5563 3.48776 1.93902 0.914664

Pmr 0.031689 -0.0203097 a-MM -0.972658 -0.87741

0.319331 -2.02871 -4.66885 -3.54634

Ilr -0.050309 0.066191 'Yml -0.917606 -0.612233

-0.531951 0.860386 -6.28237 -3.70809

P2r -3.34453 -1.49213 Ym2 -1.68526 -0.318282

-2.83301 -3.39262 -1.69856 -0.625071

P3r 4.98317 2.18391 Ym3 2.82585 0.933733

3.01428 3.47576 2.05143 1.29348

4r -2.07623 -0.878857 Ym4 -1.25581 -0.506554

-3.16477 -3.46395 -2.31612 -1.73893

Prr -0.761543 -0.640011 Pi 1.01414 1.09604

-6.33353 -8.37801 81.6327 39.585

al -1.02571 -1.08343 lk -0.74533 -0.130297

-98.2394 -45.8247 -2.2525 -0.372145

atlk 0.273067 -3.21572 rii 7.97461 4.87276

0.796953 -0.920726 1.93964 2.25312

aO11 -0.333291 -0.387216 12 1.25326 0.525427

-2.31578 -2.55631 0.98912 0.097219

atim 0.344917 -0.12676 13 -2.80924 -0.7562

2.9052 0.712326 -1.78075 -1.1406

'Yni -0.067936 0.05436 114 1.32417 0.436595

-0.583739 0.434707 2.18741 1.6799

'Y12 -2.68923 -0.785898

-2.41714 -1.83519

'Y13 3.99511 1.30185

2.57121 2.14026

'Y14 -1.65951 -0.574926

-2.70326 -2.34684
PP SCG

Equation R2 Durbin-Watson R2 Durbin-Watson

Output 0.950401 1.21012 0.914576 1.3508

Labor 0.976429 1.05238 0.958801 1.19269
Materials 0.934851 1.27183 0.899135 1.39501

restrictionsfor theseelasticitiesto be zero aregivenby decreasingin variance.Unfortunatelyall parametersthatdo

not involve w, V1I,or r are lost in the differentiationof the
'Yij + oir = ? indirectutility function.Consequentlysome of the param-
j = 2, 3, 4, i =l, m. (26)
eters involving the second momentsdo not appearin our
131i + PA,3y =? estimatedsystem, so that we cannot check whether V is
increasing or decreasingin the second moment.We can,
We test andrejectthese restrictionsfor bothindustries,thus
however, check this indirectly.As is well known,with risk
rejectingthat productiondecisions are (locally) unaffected
aversion, output will be lower underuncertaintycompared
by highermoments.14 Again,this impliesthatriskneutrality
with the certainty(or riskneutrality)case.'5The converseis
mustbe rejected.
Having rejectedrisk neutrality,can we go furtherand 15
determinethat we actuallyhave risk aversion?One way to we See Sandmo(1971).To see this,notethatsinceinputpricesareknown,
can obtain the optimal level of output from the problem
check if there is risk aversion is to see whether V is maxyE{U[(p + rE)y - C(w, y) - r]}, where C(w,y) is the usual cost.
function (which implies that VilVj = CVlCj).This yields the first-order
arerejected,it is
14 Giventhatthe local restrictions clearthatthe global conditionp5= aClay+ f, wherea = - [cov(U', p)]IE(U') is themarginal
restrictionswill be rejectedas well. Withrisk aversionthe "full marginalcosts"aregiven
cost of uncertainty.
636 THE REVIEW OF ECONOMICSAND STATISTICS

TABLE 2.-ELASTICITIES EVALUATED AT THE POINT OF APPROXIMATION Looking at the supply function, we find that supply
PP SCG elasticities are significantly positive with respect to the first
Elasticity Estimate t-Statistic Estimate t-Statistic moment (expected output price), but significantly negative
with respect to the second moment, for the two industries.
Oil 0.0159 0.1438 0.0160 0.1603
012 -0.7227 -2.962 -0.7667 -3.851
Hence a higher expected output price will increase the
013 1.0881 3.087 0.9823 3.401 supply of output, but a higher variance will decrease it. Thus
014 -0.45831 -3.183 -0.34820 -2.954 (assuming that U does not change sign), we conclude that for
0mi 0.8490 5.014 0.6098 4.582
-1.6927 -4.020 -1.2095 -3.846
both industries we have statistically significant risk aversion.
0m2
0m3 2.2134 3.671 1.3548 2.964 As for supply elasticities with respect to the third and fourth
0m4 -0.8453 -3.479 -0.4290 -2.292 moments, we find that they are significantly positive and
Oyl 6.8130 1.680 3.5119 1.797
-2.1087 -2.838 -1.4441 -3.665
negative, respectively, for both industries. Our findings that
oy2
oy3 2.2130 3.255 1.4939 3.661 demand and supply functions are upward sloping with
0y4 -0.7705 -3.287 -0.4805 -3.175 respect to expected output price, but downward sloping with
Oil -0.4536 -3.347 -0.3983 -2.975
Oin -0.3045 -2.366 -0.0861 -6.018
respect to the variance, are consistent with the standard
Oml -0.1166 -0.991 0.3568 2.538 results, for the case of a risk-averse firm with decreasing
omm - 0.0149 -0.076 -0.4240 -1.831 absolute risk aversion.17
Oyl 0.1544 1.471 0.2939 2.920
oym -0.6830 -4.293 -0.3142 -2.345
Next we calculate demand and supply input price elastici-
ties, which are given by

Otij Otrj

also true, that is, if output is lower under uncertainty, we

r
must have risk aversion. It is therefore possible to check for
risk aversion by comparing output levels with and without OXii Otri
uncertainty (or with risk neutrality). To obtain the values for Oii =-- -1, i 1, m (27)
output under certainty we note that without uncertainty, V 6i 6r

becomes the usual profit function, which is linear homoge-

neous in w, V1, r.16 This is obtained by imposing linear
homogeneity (in w, V1, r) and the requirement that aVhar=
-1, I3jg= 0 for all j = 2, 3, 4. Thus we estimate the model
with these restrictions imposed and use the parameter
estimates to calculate the predicted values of output, for both
industries. Comparing the estimated values of output with
the actual ones, we find that output in the restricted case (no
uncertainty)is higher than output under the unrestrictedcase
(with uncertainty) for all observations. Thus we conclude
that we do indeed have risk aversion.
The estimated elasticities with respect to the moments of
the price distribution, calculated at the point of approxima-
tion, and their standard errors are reported in table 2. As
table 2 shows, the elasticities of labor with respect to all
moments have the same sign as the those of materials with
respect to these moments. Specifically, input elasticities with
respect to the first moment (expected output price) are
significantly positive, whereas input elasticities with respect
to the second moments are significantly negative for the two
industries. Hence a higher expected output price will
increase demand for both inputs, but a higher variance will
decrease it. As for input elasticities with respect to the third
and fourth moments, we find that they are significantly
positive and negative, respectively, for both industries.
by aClay+ 1, where1 > 0. Thusoutputwill be lowerthanin the case of
riskneutrality,or no uncertainty(when1 = 0). Note thatit is the standard 17 See Sandmo(1971) andAppelbaumandKatz(1986).
practicein such comparisonsto takethe pricein the certaintycase as the
expectedprice(see referencesin footnotes1 and2).
16 In this case the problemis simply to maximizeprofits, rr = ply-
C(w, y) - r, where C(w, y) is the usual cost function.
oyj -^ , j =1,m.
6 r'
These elasticities are given in table 2. Table 2 shows that all
the own price elasticities of demand have the right sign,
indicating that the demand functions are negatively sloped.
Cross price elasticities of demand are usually not symmet-
ric. Under uncertainty, however, the cross price elasticities
of demand, Oij and Oji,do not even have to have the same
sign.18 Indeed, as table 2 shows, demand elasticities are
"sign symmetric" in the PP industry (labor and materials are
mutually substitutes), but not in the SCG industry.
Our empirical results indicate that uncertainty had a
statistically significant effect on production decisions. This
was due to the fact that risk neutrality was rejected in both
industries. The rejection of risk neutrality and the estimated
effects of uncertainty on supply and demand suggest that
uncertainty resulted in lower output produced (inputs used).
What does this imply from a welfare point of view? First, let
us consider the welfare implication for a given expected
output price. With risk aversion, the "full" marginal costs19
are higher due to the presence of marginal costs of uncer-
tainty. The marginal costs of uncertainty are absent in the
case of risk neutrality (or no uncertainty), which is the
reason why output is higher in that case. Clearly, a lower
18 To see this, assume that 0,i > 0. Then we must have
OLij
> OLrLji18,r =
(oLri,jI8r)(OLrj8ijILrij8j) But given this, it is still possible to have oLijK
< ,i8jl8n
which is required for Oji< 0.
19See footnote 15.
 PRODUCTIONDECISIONS UNDER UNCERTAINTY 637

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