On pricing and quality decisions with risk aversion

Abstract

This paper considers pricing and quality decisions for a product in a firm which is concerned about demand risk stemming from uncertainty as to customers’ valuation. A stylized model is built on the basis of the expected utility theory, and the optimal solutions are characterized under very mild conditions in the scenarios of risk neutrality and risk aversion respectively. It is found that when either price or quality is the sole decision variable, the optimal price decreases with a higher level of risk aversion whereas the optimal quality increases with it. In comparison, when both price and quality are decision variables, a more risk-averse firm will set the product’s price and quality at a lower level simultaneously. This is due to the mutual reinforcement effect between these two decision variables as strategic complements. This effect further enhances the impacts of risk aversion, leading to more radical changes in marginal profit and product price-performance as the risk aversion degree varies. Hence, compared to a single variable, risk aversion is a more serious issue in the presence of both the decision variables in question.