Risk-Averse Firms in Oligopoly

Does risk aversion lead to softer or fiercer competition? To give a complete answer, I provide a framework that can accommodate a wide range of alternative assumptions regarding the nature of competition and types of uncertainty. I show how more risk aversion will influence a firm’s best response strategies, and that competition is unambiguously softer only in case of marginal cost uncertainty. In contrast to risk neutrality, the best response strategies depend on the level of fixed costs. This fact is extended to cover strategic investment models, and to analyze the importance of accumulated profits. I conclude by a discussion of how it is possible to test for risk-averse behaviour in oligopoly by conditioning on the type of uncertainty.

Introduction: A standard assumption in oligopoly theory is that firms are risk-neutral. However, there are several reasons for why firms may act as if they were risk-averse. Some of the factors that can be invoked are non-diversified owners, liquidity constraints, costly financial distress, and non-linear tax systems. And even if owners themselves wish to maximize expected profits,delegation of control to a risk-averse manager, whose payment is linked to firm performance,may cause the firm to behave in a risk-averse manner. Empirically, the reluctance to bear risk is evidenced by the extent of corporate hedging activity (see e.g. G├ęczy et al., 1997, Tufano, 1996, and Nance et al., 1993). In spite of this, surprisingly little work has focused on the effects of risk aversion on competition. In particular, there has been very little effort spent on trying to derive empirically testable predictions regarding the effects of risk aversion on competition…

Author: Marcus Asplund

Source: Stockholm School of Economics

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