MANAGERIAL AND DECISION ECONOMICS, zyxw VOL. 13, 389-397 (1992) Price Uncertainty and the Effect of Capital Costs in a Point in-Point out Inventory Investment Anders Thorstenson and Peter Hultman zyxw Linkoping Institute of Technology, Sweden This paper analyzes a point in-point out inventory investment under price uncertainty. The optimal quantity is determined by maximizing the expected value of the investor’s risk preference function, which is a function of profit. Using an exponential risk preference function, the adjustment in the optimal quantity stemming from a change in the interest rate is investigated. The main conclusion is that the sign of the adjustment depends both on how profit is expressed and on the type of price distribution applied. Contrary to what is assumed in conventional managerial control practices, a rise in the interest rate might lead to an increase in the optimal quantity when present value serves as a measure of profit. INTRODUCTION There is a large number of studies in the literature on the subject of how the competitive firm’s optimal output is affected by uncertainty in the selling price. The expected-utility-maximizingfirm’s attitude to- wards risk has been found to be decisive when comparing the optimal output under different cir- cumstances. It has also been shown that the impact of changes in parameters (such as expected value and riskiness of the stochastic selling price, fixed production costs and rate of taxation) is dependent on the type of risk behavior that the firm follows. These issues have been studied by, among others, Sandmo (1971) and Leland (1972). Contributions have also been made by e.g. McCall(1967), Roths- child and Stiglitz (1971), Batra and Ullah (1974), and Ishii (1977). Further references are found in a comprehensive review of the problem by Lippman and McCall (1 981). The question posed in this paper is: How is the competitive firm’s optimal quantity under price uncertainty affected by changes in capital cost? Our purpose is to derive a partial answer in the form of results for the type of problem referred to above when interpreted as a simple buy/store/sell situation. In industry it is a common practice to determine ordering quantities as a trade-off between, on the one hand, the costs associated with ordering and, on the other, the costs of holding inventory. Larger ordering quantities means higher inventory levels and more capital tied up. In this framework an increase in the cost of capital will lead to lower ordering quantites (and lower inventory levels), and this relationship is frequently utilized by the management in companies. By changing the cost of capital used for procurement or production de- cisions, managers on lower levels are supposed to react correspondingly, which will lead to a desired change in average inventory level. The question that arises is: Can a company or a manager with a certain attitude towards risk and with a perceived uncertainty in a key parameter always be expected to react in this way? In the same type of model studied here it was shown in Hultman and Thorstenson (1987)that risk aversion is not a sufficient condition for a decision maker to decrease the ordering quantity when the cost of capital increases. When profit is expressed as revenue minus cost, a company or a manager with non-increasing absolute risk aversion will always decrease the ordering quantity in response to an increase in the cost of capital. In this paper the aim 0143-6570/92/05038949$09.50 zyxwvu 0 1992 by John Wiley zyxwvuts & Sons, Ltd.