Demand Uncertainty Reduces Market Power and Enhances Welfare

Abstract

Classical welfare economics assumes that the demand function, or consumers’ utility, is known with certainty. Probabilistic microeconomics generalizes it by maximizing expected utility, or by optimizing under a specific constraint. Existing research has provided only limited insight into the welfare effects of demand uncertainty, and that limited insight suggests welfare reduction as a result of demand uncertainty. In contrast with previous works, our paper does not prescribe the form of demand uncertainty, but rather derive it from individual consumers’ choices. We then analyze monopolist optimization problem, first constrained by a “Safety-First†type condition imposed on the coefficient of variation, and then by considering risk-adjusted profit measure. Our results indicate that the Marshallian welfare measure, when compared with the deterministic model, increases with uncertainty of the demand function. We point out that uncertainty characterizes markets that lie between the pure monopoly model, and perfect competition model. We believe that our model of demand uncertainty is a realistic one, very much like observed behavior of markets. Most importantly, our work suggests that transition from monopolistic market structure to competitive one may be explained better by demand uncertainty than by mere presence of competitors, as opposed to the instant appearance of competitive pricing in common textbook models. Finally, we show how a demand can be efficiently estimated from simple consumer surveys (admitting its random structure).