Hedging and Production Decisions Under a Linear Mean-Variance Preference Function

A firm model of production and hedging decisions is developed using a mean-variance preference function. Comparative static analysis of the model generates a number of testable hypotheses. For example, the influence of price risk, production risk and hedging cost on the optimal level of production and hedging is analyzed in this framework. The Theory of production decisions for a risk averse firm under uncertainty has been examined extensively in the literature [Ba-ron, Sandmo, Batra and Ullah, Pope and Kramer]. The use of futures trading as a price risk management tool for farmers has also been analyzed [Heifner; Ward and Fletcher]. More recently, Danthine, Holthausen and Feder, et al. (hereafter DHF) have attempt-ed to integrate these two approaches. They developed a model that extends the theory of the firm under price uncertainty in a way especially relevant for agricultural firms by considering futures markets. In the DHF model, as input decisions are made, the pro-ducer decides to hedge by selling contracts in the futures market for delivery at the end of the production process. Although the cash price is uncertain at the time of the input decision, the futures price is known with certainty, and basis risk is presumed to be insigificant.1 Also, the DHF model assumes Jean-Paul Chavas is an Assistant Professor and Rulo