Uncertainty and the microfoundations of supply response : some theoretical considerations and an empirical application in the U.S. corn market
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This study has examined how a micro-level decision model which incorporates uncertainty can be reconciled with observed market behavior. Conditions under which a firm-market correspondence exists in a deterministic environment are well defined. However, similar relationships have not been developed when agents are risk averse. A detailed theoretical framework is presented which establishes the conceptual linkages between the firm and market. A unique feature of the theory is that agents have rational expectations about all relevant moments of the equilibrium price distribution. The theoretical model is extended to admit the possibility of government intervention. The stylized voluntary government program includes planting restrictions and price supports. The rational expectations hypothesis is appropriately amended to allow for the truncation effect of the price support on the moments of the price distribution. Although many questions pertaining to industry behavior and program design can be addressed with the theory, it is ultimately necessary to test the theoretical implications with an empirical model. The U.S. corn market is used in an empirical application. Importantly, the supply equations are derived from an expected utility maximization framework. In addition, the correspondence between the firm and market is maintained and the rational expectations hypothesis, including truncation effects, is fully incorporated. Supply equations and input demands are also estimated for both participants and nonparticipants in the government program. The empirical model provides a rich framework for conducting policy analysis. For instance, it is possible to experimentally determine certainty equivalent income tradeoffs between acreage restrictions and price supports. The empirical results indicate that relatively large increases in the set-aside requirement can be compensated for by small increases in the support price. This result follows directly from the truncation effect of price supports on producer expectations and illustrates the importance of risk in stabilization analysis.
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