Price uncertainty and the heightening effect of background risk

Abstract In the standard model of competitive firm behavior under output price uncertainty, entrepreneurs’ aversion to risk entails under-production as a form of hedging. Moreover, the occurrence of uninsurable background risk may generate a tempering effect on endogenous risk exposure, leading to further output cutbacks. Consistent with recent empirical evidence on firms’ behavior in competitive environments, this paper theoretically characterizes over-production relative to the certainty benchmark as the optimal firm’s reaction to multiple interacting risks. First, a global sufficient condition on the risk dependence structure is provided under which any risk-averse entrepreneur will find it optimal to expand output beyond the certainty level, irrespective of higher-order risk attitudes (e.g. prudence) and of the risk size. Second, over-production is shown to obtain under relatively milder conditions on the joint risk distribution, provided risks are sufficiently small. Again, no further restrictions on entrepreneurial preferences are to be imposed.