Price uncertainty and the heightening effect of background risk
Year: 2025
Type: article
Abstract: In the standard model of competitive firm behavior under output price uncertainty, entrepreneurs’ aversion to risk entails under-production as a form of hedging. Moreover, the occurrence of uninsurable background risk may generate a tempering effect on endogenous risk exposure, leading to further output cutbacks. Consistent with recent empirical evidence on firms’ behavior in competitive environments, this paper theoretically characterizes over-production relative to the certainty benchmark as the optimal firm’s reaction to multiple interacting risks. First, a global sufficient condition on the risk dependence structure is provided under which any risk-averse entrepreneur will find it optimal to expand output beyond the certainty level, irrespective of higher-order risk attitudes (e.g. prudence) and of the risk size. Second, over-production is shown to obtain under relatively milder conditions on the joint risk distribution, provided risks are sufficiently small. Again, no further restrictions on entrepreneurial preferences are to be imposed.
Source: Theory and Decision
Author: Marco M. Sorge
Institutions: University of Salerno, University of Göttingen
Language: English
Subfield: General Decision Sciences
Field: Decision Sciences
Domain: Social Sciences
Open Access status: hybrid
Estimated APC paid: $3,190
OpenAlex ID: W4414410820