Production Flexibility and Hedging

Abstract

A risk-averse firm faces uncertainty about the spot price of the output, but has access to a futures market. The technology requires both capital and labor to produce the output. Due to the presence of flexibility in production, the level of capital and the volume of futures contracts are chosen under uncertainty (i.e., prior to observing the realized spot price) whereas the level of labor is set under certainty (i.e., after observing the realized spot price). When there is flexibility in production, the optimal production decisions are different between a risk-neutral firm and a risk-averse firm, i.e., the separation result does not hold. Moreover, flexibility in production implies only partial hedging with an actuarially fair futures price, i.e., the full-hedging result does not hold.