CRIEFF Discussion Paper Number 0209

Competitive Firm Behaviour With Simultaneous Price and Output Uncertainty

Ardeshir J. Dalal and Moavia Alghalith

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Abstract

When modeling output uncertainty, the multiplicative specification is consistently
chosen over the additive form, despite the latter being arguably intuitively more obvious.
The rationale for this seems to be that when production risk is the only source
of uncertainty, additive uncertainty does not reduce output below the certainty level,
while multiplicative uncertainty does. We show that, regardless of the specification
of output uncertainty, if hedging is absent and there is simultaneous price and output
uncertainty, output is always lower than the situation in which one or both sources of
uncertainty are absent. Thus, both models yield qualitatively identical results, i.e.,
adding a source of uncertainty reduces expected output. Therefore, additive uncertainty
is indeed a reasonable a priori method of modeling production uncertainty.

Key Words
Multiplicative output uncertainty, additive output uncertainty, price uncertainty.
JEL Classifications
D21, D81

Ardeshir J. Dalal
Northern Illinois University

Moavia Alghalith
University of St Andrews

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