Uncertainty, Market Structure and Performance: The Galbraith-Caves Hypothesis Revisited
The Galbraith-Caves conjecture that ".. a significant portion of the potential profits in... (a firm's)... position of market power is taken in the form of avoiding uncertainty " [Caves, 1970, p. 284] has recently received theoretical and empirical attention in an important paper by Edwards and Heggestad [19731—henceforth referred to as EH. Following Lintner [1970] and others, EH assume that price-setting firms maximize the expected utility of profits. A specific utility function, (1) U(11) = a — be-2"f 1, is employed, where a and b are constants and 2a is the coefficient of absolute risk aversion. Assuming further that Fr oi), maxi-mizing expected utility can be shown to be equivalent to maximizing the certainty equivalent (2) = — «air. The expression for the firm's expected utility, or equivalently II, yields indifference curves in H space that are linear with a positive slope equal to lia. Market opportunities open to the firm are contained in the "efficient opportunity set, " a notion borrowed from the theory of finance [Edwards and Heggestad, 1973, p. 461]. Preferences and opportunities are brought together in Figure I, which constitutes the crux of EH's theoretical analysis. In addition to determining the firm's optimal II, a 2 „ configuration, e.g., points X and Y, the diagram is used to show that (i) higher risk aversion (a condition that is thought to characterize the management of firms with market power) 1 or (ii) a uniform, rightward, shift of the efficient opportunity set (firms with greater market power are thought to be able to extract _ more expected profit for any given variance of profit) will lower o-2,r/II, the EH measure of risk undertaken by firms. The We are indebted to F. R. Edwards, J. Green, A. A. Heggestad, and C. Southey for helpful comments on an earlier draft. 1. For a discussion of this proposition, the reader is referred to, among others,