Introduction and summary

The purpose of this chapter is to point out that uncertainty about the price elasticity of demand has an effect comparable to that of a kink in the demand curve, for a risk-averse firm; the kink being located at the prevailing price and quantity. The reason for this effect, namely estimation uncertainty, is entirely distinct from the standard reason invoked in the literature on kinky demand curves, since Sweezy (1939), namely asymmetrical reactions of competitors. Thus symmetrical, but imperfectly known reactions would produce asymmetrical effects. And asymmetrical, but imperfectly known, reactions would produce doubly asymmetrical effects – the asymmetry generated by uncertainty being compounded with that generated by the reactions themselves.

The effect of uncertainty in the context considered here is analogous to the effect of uncertainty about rates of return on savings decisions by consumers. Variance of rates of return affects these decisions in the same way as adverse changes in expected returns – see Drèze and Modigliani (1972) or Sandmo (1974). Thus, uncertainty about rates of return has an effect comparable to that of a kink in the budget line constraining present and future consumption; the kink being located at the endowment point. (The reason for that kink is again distinct from the standard reason, namely a difference between lending and borrowing rates; both asymmetries must again be compounded.)