Optimal Markup Decisions under Demand Uncertainty

Abstract

This article examines the consistency with economic theory of a rule of thumb in which a risk‐averse firm facing demand uncertaintly sets its price based on a percentage over the price paid to farmers. A testable set of comparative static results determines how the optimal markup is influenced by shifts in key parameters affecting the firm: expected demand, demand uncertainty and average variable costs. The model is tested using data from the wholesale markets for organic lettuce, broccoli and carrots. The results demonstrate that risk‐averse wholesalers raise markups as expected demand increases and reduce them as uncertainty increases, consistent with risk‐averse behavior. The empirical models show that produce marketing agents monitor shifts in expected demand and demand variability when adjusting markups. Expected demand has a greater impact on markups than demand variability.