Background risk and the theory of the competitive firm under uncertainty

Abstract

This paper examines the optimal production decision of a firm under output price risk à la Sandmo when the firm also faces a dependent background risk. It is shown that standard risk aversion plus a non-negative association between the output price risk and the background risk are sufficient to ensure a reduction in the firm's optimal output upon introduction of the background risk. The paper investigates the impact of a deterministic transformation of the background risk on the firm's optimal production decision. It is shown that decreasing absolute risk aversion in Ross' sense is among the sufficient conditions that generate an unambiguous negative comparative static result.