Prudence, Demand Uncertainty, Background Risk, and the Law of Supply: A Nonexpected Utility Approach to the Firm*
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
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Volume (Year): 22 (1997)
Issue (Month): 1 (June)
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