The Effect of Probabilistic Demands on the Structure of Cost Functions.

Firms that provide capacity to meet randomly fluctuating demand typically will not be producing on the efficient frontier of their production possibilities sets. Consequently, the standard dual theory of cost and production is inapplicable. This article provides an alternative that leaves most of the theory intact provided that firms are viewed as producing the probability of providing services rather than an explicitly produced output. As an application we show that for a telecommunications firm facing a network externality it is quite possible to find something that looks like negative marginal cost. Copyright 1990 by Kluwer Academic Publishers