INVESTMENT AND INPUT CHOICES OF A MONOPOLISTIC FIRM UNDER DEMAND UNCERTAINTY: A LONG RUN ANALYSIS

Abstract

In this paper we investigate the optimal behavior of a monopoly under demand uncertainty by a long run analysis using dynamic programming. The monopoly which we would consider is the kind of price/quantity adjusting firm. Investment the firm undertakes for each period must choose before demand uncertainty is not resolved, and capital stock is determined in the same way. But, labor input for each period is chosen after a stochastic variable and capital stock are known. Then, labor input is determined so as to maximize the short run profit at each period. On the other hand, investment for each period is chosen so as to maximize the expected utility of the sum of discounted net cash flows.
We summarize the outcomes of our analysis below. The risk-averse monopoly does not choose capital stock and labor input at the point of the expected marginal rate of technical substitution equal to the slope of its iso-cost line and, therefore, does not adopt the strategy of the expected cost minimization, that is, the monopoly uses an expected capital-labor ratio less than the efficient ratio. Also the risk-averse monopoly uses a smaller amount of capital stock than the expected cost minimizing amount for the level of output produced. Moreover, the risk-neutral monoply chooses a larger investment and capital stock than the risk-averse monopoly.