When Should Firms Expose Themselves to Risk?

Abstract

I analyze a firm making a decision whether to expose itself to risk in an exogenous parameter when the firm can change a choice variable after observing the realization of the exogenous parameter. For example, the firm decides whether to choose an advertising campaign with a less certain outcome (conditional on the same expected outcome) when it can adjust the product’s price after seeing the effects of the campaign. I show that in many cases, the firm wants to expose itself to risk, and I outline general conditions that need to be satisfied for this result. I then analyze the strategic version of this setup with two competing firms, provide a general characterization, and show that in many cases both firms want to expose themselves to risk, as long as the risks are not too positively correlated. This is the case for many linear demand and constant marginal cost settings (monopolies, differentiated Bertrand firms, or differentiated Cournot firms selling substitutes) where the exogenous parameter is a demand, or a marginal cost shifter results in the monopoly (or both of the competitors if the risks are not too positively correlated) voluntarily exposing itself to risk. This paper was accepted by J. Miguel Villas-Boas, marketing.