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Prudence, Demand Uncertainty, Background Risk, and the Law of Supply: A Nonexpected Utility Approach to the Firm*

Author

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  • Fanny Demers

    (Department of Economics, Carleton University, Ottawa, Ontario K1S 5B6, Canada)

  • Michel Demers

    (Department of Economics, Carleton University, Ottawa, Ontario K1S 5B6, Canada)

Abstract

We identify two motives, prudence and risk aversion, which give rise to precautionary behavior for a quantity- or price-setting monopolist facing demand uncertainty who has dual theoretic preferences. We also analyze a piecewise linear profit function due to a tax on profits that varies with the profit level. We show that the comparative statics of greater risk (mean-preserving spread and mean-utility preserving spread) can be totally or partially determined by the Diamond-Stiglitz and Kihlstrom-Mirman single-crossing property. For example, for a prudent risk-averse quantity-setting dual theoretic monopolist, a mean-preserving spread will have the same impact on output under uncertainty as a fall in the state of demand under certainty. Finally, we find that, in contrast to expected utility, a stochastically larger state of demand (first-order stochastic dominance) will raise output even if background risk is present. The Geneva Papers on Risk and Insurance Theory (1997) 22, 21–42. doi:10.1023/A:1008607313575

Suggested Citation

  • Fanny Demers & Michel Demers, 1997. "Prudence, Demand Uncertainty, Background Risk, and the Law of Supply: A Nonexpected Utility Approach to the Firm*," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 22(1), pages 21-42, June.
    • Handle: RePEc:pal:genrir:v:22:y:1997:i:1:p:21-42
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