Prudence, Demand Uncertainty, Background Risk and the Law of Supply : A Nonexpected Utility Approach to the Firm

We identify two motives, prudence and risk aversion, which give rise to precautionary behaviour for a quantity or price setting monopolist facing demand uncertainty who has dual theoretic (DT) preferences. We also analyze a piecewise linear profit function due to a tax on profits which varies with the profit level. We show that the comparative statics of greater risk (mean-preserving spread (MPS) and mean- utility preserving spread (MUPS)) can be totally or partially determined by the Diamond-Stiglitz [1974] and Kihlstrom-Mirman [1974](DSKM) single-crossing property. For example, for a prudent risk averse quantity-setting DT monopolist, a MPS will have the same impact on output under uncertainty as a fall in the state of demand under certainty. Finally, we find that, in contrast to expected utility, a stochastically larger state of demand (first order stochastic dominance) will raise output even if background risk is present