Was Sandmo Right? Experimental Evidence on Attitudes to Price Risk and Uncertainty
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In his seminal 1971 article, Sandmo showed that when faced with
an uncertain output price, a risk-averse firm manager would hedge by
producing less than he would have when faced with a certain output
price. We take Sandmo’s prediction, among other things, to the lab.
We study in turn the effects of price risk (i.e., uncertain prices whose
distribution is known) and price ambiguity (i.e., uncertain prices whose
distribution is not known, but whose range is known) while controlling
for our subjects’ income risk preferences. Our experimental protocol
closely mimics Sandmo’s theoretical model. For price risk, we use a
two-stage randomization strategy aimed first at studying the effect
of price uncertainty relative to price certainty, and then the effect of
increases in price uncertainty conditional on there being price uncertainty.
For price ambiguity, we use the same randomization strategy to
study the effect of price ambiguity relative to price certainty while preventing
our subjects from guessing the shape of the price distribution.
For price risk, we find that, in stark contradiction to Sandmo’s theoretical
result, the presence of price uncertainty causes subjects to produce
more than they do under price certainty, but that increases in price
uncertainty makes them decrease their production monotonically. For
price ambiguity, results are mixed and depend on whether the portion
of the experiment aimed at eliciting our subjects’ income risk aversion
is played before or after the price uncertainty game. Lastly, we use
our price risk data to study the problem structurally, in order to get
at preference heterogeneity, and find that our structural results are
consistent with our reduced-form results.