Industry equilibrium, uncertainty, and futures markets

This paper studies competitive long-run industry equilibrium with uncertainty and futures trading. We also provide a long-run analysis of futures trading instead of the conventional short-run analysis. It is shown without using a general equilibrium model that, given uncertain demand and risk aversion, a bias (backwardation or contango) arises in long-run industry equilibrium. Given risk neutrality such a bias, however, disappears. We find that the occurrence of the bias depends not only on the existence of a risk premium, but also on the length of the period considered. Each risk-averse firm operates at a less efficient scale and, moreover, an expected spot price never accords with marginal cost. When the expected spot price is less than marginal cost, the risk-averse firm can secure profit by selling futures contracts more than the amount of its output. In the presence of production (supply) uncertainty a risk-neutral firm operates with excess capacity under additive risk, while the firm operates with proper capacity under multiplicative risk. The key lies in whether its average cost curve is shifted by production risk.