Pricing as a Risky Choice: Uncertainty and Survival in a Monopoly Market

Per Andersen,Henrik Vetter

doi:10.5018/economics-ejournal.ja.2015-29

Per Andersen, Henrik Vetter

Open Access

https://doi.org/10.5018/economics-ejournal.ja.2015-29

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Journal: Economics	Publication Date: Oct 1, 2015
Citations: 2	License type: CC BY 4.0

Affiliation: University of Southern Denmark, Aarhus University

Abstract

AbstractRoy (Safety First and the Holding of Assets,1952) argues that decisions under uncertainty motivate firms to avoid bankruptcy. In this paper, the authors ask about the behaviour of a monopolist who pre-commits to price when she has only probabilistic knowledge about demand. They argue that pricing in order to maximise the likelihood of survival explains anomalies such as inelastic pricing, why the firm takes on more risk as gains become less likely, and asymmetric responses to demand and cost changes. When demand is a linear demand, the monopolist’s response to an increase in the marginal cost is similar to the response when mark-up pricing is used. That is, there is a one-to-one relationship between an increase of the marginal cost and an increase in price.

Highlights

Following Sandmo (1971), one of the shortcomings of assuming that firms maximise expected profits when they make decisions under uncertainty, is that they ignore the consequences of losses, including the possibility of bankruptcy
Kimball (1989), who assumes that marginal costs are convex, shows that a monopolist who commits to price before observing demand will charge a higher price as uncertainty increases
The case appears that many firms diverge from the pure profit-maximising behaviour because they use mark-up pricing

Summary

Introduction

Following Sandmo (1971), one of the shortcomings of assuming that firms maximise expected profits when they make decisions under uncertainty, is that they ignore the consequences of losses, including the possibility of bankruptcy. With respect to cost-changes, a higher fixed cost increases the optimum price under the safety-first criterion while the price is unrelated to a fixed cost when firms maximise expected profit. Kimball (1989), who assumes that marginal costs are convex, shows that a monopolist who commits to price before observing demand will charge a higher price as uncertainty increases This result is based on the observation that marginal production cost increases in all states for a mean-preserving spread, and, ignores the chance that the firm ends up in a situation of financial distress. Our findings reverse existing conclusions on the implications of the safety-first principle, as we show that a price-setting monopolist hedges against risk by lowering the price relative to the one that maximises expected profit.

Price decisions and survival

Cost changes

Inelastic Pricing

Discussion