Output Decision Under Demand Uncertainty with Stochastic Production Function: A Contingent Claims Approach

Abstract

This paper presents a contingent claims analysis of output decisions for the firm facing technological and demand uncertainty. The paper reveals that: (i) the optimal output level increases with the higher interest rate when the firm is subject to demand (and technological) uncertainty; (ii) the effect of demand volatility and production lead time on the optimal output level could be either positive or negative; (iii) the optimal project value decreases with the higher demand volatility; (iv) the optimal project value decreases with the longer production lead time when the firm is subject to demand uncertainty; and (v) the optimal project value decreases with the higher interest rate when the firm is subject to demand uncertainty; it increases with the higher interest rate, however, when the firm is subject to both demand and technological uncertainty. Some important managerial implications are discussed.