Testing the theory of the firm under price and background risk

Abstract A generalized version of the classical model of the firm under risk is proposed in order evaluate the effects of an increase in price risk on a firm's production choices where background risk is present. It is shown theoretically that in this setting, these effects are ambiguous. This purely analytical result is then tested empirically using survey data on manufacturing firms in Chile. The results indicate that an increase in price risk induces greater production levels across the entire sample, thus revealing the presence of a precautionary effect. When the sample is divided on the basis of firm size, however, evidence of significant heterogeneous effects is found. While larger firms exhibit a precautionary effect, smaller firms display a strong substitution effect that prompts them to reduce output levels.