Production and Risk Management in a Multi-Period Duopoly Under Demand Uncertainty

Abstract:     
This paper follows up on Broll et al. (2011) and considers a Cournot duopoly under demand uncertainty. Firms maximize (mu, sigma)-preferences and are able to hedge their production on a forward market. The paper is concerned with the effects of production and hedging decisions on future interactions in the duopoly. We are the first to consider the duopoly under uncertainty with a hedging opportunity in a dynamic setting. We introduce storage to the model and investigate the effects of the possibility of storage on the output, sales and hedging decisions of the firms in a multi-period setting. We show that firms indeed consider long-term ramifications of their decisions and thus models which only contemplate short term utilities in a one period world neglect important repercussions. However, the sign of the effect on future decisions is ambiguous. Thus, future research should set the focus on dynamic settings when considering risk management questions in imperfect markets. In a multi-period setting with storage the separation theorem does not hold, but a variation of the full hedge theorem is valid.

Keywords: Price risk, hedging, dynamic setting, storage, duopoly

JEL Classification: D21, D43

Accepted Paper Series