Abstract
The literature recognizes the qualitative effects of risk aversion on oligopolistic market performance, but less is known about their magnitudes. We quantitatively evaluate these effects in Cournot and Bertrand oligopolies where firms maximize mean-variance utilities under linear demand and costs. The impacts are very similar for the two types of oligopoly, but have opposite signs. The impacts of a firm’s risk aversion on outputs, prices, consumer surplus and social welfare can be expressed via potentially observable variables. Since these impacts resemble the effects of firms’ cost changes, a regulator can reduce or eliminate undesirable effects of risk aversion by changing firms’ costs with appropriate countervailing taxes.
Highlights
Firms’ behavior under uncertainty can be strongly affected by risk aversion
In this paper we quantitatively evaluate the impact of a firm’s risk aversion on outputs, prices, consumer surplus and social welfare
We can quantitatively estimate these effects based on observable variables, excluding unobservable risk aversion
Summary
Firms’ behavior under uncertainty can be strongly affected by risk aversion. For the case of banks, this is clearly demonstrated by the recent financial crisis, during which big banks’ behavior changed dramatically and led to significant consequences. Inter-bank loans shrank to nearly zero after the downfall of Lehman Brothers in 2008 and this unexpected reaction put the global financial market at a serious risk To understand this phenomenon, we need to know the qualitative features of the impact of risk aversion, and its magnitude. As Baron points out, the reverse holds if a monopolist faces an uncertain quantity and chooses its price Later researchers extended this analysis to oligopoly and examined the impact of risk aversion under both demand and cost uncertainty. Asplund (2002) further examines Cournot and Bertrand duopolies with demand uncertainty, and shows that risk aversion reduces a firm’s decision variable (output or price) and reduces (increases) the rival’s decision if their decisions are strategic complements (substitutes) These studies mainly focus on the qualitative impact of risk aversion, not on its quantitative evaluation.
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