This chapter investigates the implications of risk for production decisions. It is motivated by the fact that production decisions are often subject to uncertainty. This includes price uncertainty as well as production uncertainty. Typically, firms face many sources of risk for which risk markets are absent. Under incomplete risk markets, risk-averse firms cannot easily transfer risk to other agents. This means that, in large part, firms must manage their risk exposure privately. This chapter focuses on risk management of an owner-operated firm facing incomplete risk markets. The analysis of risk markets and contracts will be discussed in Chapter 11.

In an owner-operated firm, the manager/decision-maker is also the residual claimant. Then, in the absence of risk, the manager has an incentive to maximize profit. Indeed, as long as the manager s preferences are nonsatiated in income, increasing profit will necessarily make him/her better off. Thus, one can expect the manager to make production decisions in a way consistent with profit maximization. What happens when we introduce risk in the analysis? This chapter examines how risk affects the production decisions made in an owner-operated firm. We investigate the production behavior of a risk-averse decision-maker. This provides useful insights on the implicit cost of risk and its role in firm decisions. We start with the simple case of a single-output firm facing output price uncertainty. Then, we extend the analysis to include production uncertainty. We also examine the implications of risk and risk aversion for diversification strategies for a multi-output firm, as well...