In Chapters 2–5, we assumed that demand for the firm's output was known with certainty, so that the firm or regulator knew precisely the quantity that would be demanded once a price was set. In reality, a more complicated situation faces decision-makers. At a given price, the quantity demanded is essentially a random variable. Based on experience, the firm may have knowledge of the parameters that define the distribution of this random variable, where these parameters may be functions of the price set. However, the firm will not know the exact quantity needed to satisfy demand.

Stochastic demand can be attributed to changes in various parameters: preferences, competing technologies, incomes, prices of other goods, or the weather. Extreme weather conditions can cause unanticipated swings in the demands for electricity and natural gas, as well as transportation and communications services. How stochastic demand complicates the firm's pricing decision will depend on the nature of the product and the institutional setting in which it is produced. Although most of the examples used in this chapter are drawn from the literature on electric-power utilities, the principles that are developed apply to the other regulated sectors as well. We shall often refer to the natural monopoly firm in this chapter as a public utility.

The introduction of stochastic demand raises a number of important issues related to pricing and capacity. Leland (1972) suggests that public utilities are good examples of price-setters: firms that set prices before demand is known and then adjust output to meet demand.