The Firm’s Perception of Demand Shocks and the Expected Profitability of Capital under Uncertainty

Abstract

This paper revisits the results of the pioneering models of the firm under demand uncertainty and analyses the apparent disparity with respect to the signal of the investment-uncertainty relationship predicted by them. In the 1970’s-1980’s the modelling of demand uncertainty at the firm level taking into account the firm’s optimal choice of factor inputs constituted a cutting-edge research topic. But while setting the standards in the literature of the firm’s optimal behaviour under uncertainty, those models did not clarify the rationale behind the disparity of the results concerning the impact of increased uncertainty on the firm’s desired investment. In the context of an isoelastic stochastic demand function, where the shock variable may enter either linearly or non-linearly, we show it is the way the firm perceives the demand shocks that, by determining the shape of the profit function, establishes the signal of the investment-uncertainty relationship predicted by the model.Demand Uncertainty; Expected Profitability; Shock Perception; Jensen’s Inequality.