Risk Sensitivity and Firm Power: Price Competition with Mean2-Variance Profit Objective Under Multinomial Logit Demand

Abstract

Risk Sensitivity and Firm Power: Price Competition with Mean2-Variance Profit Objective Under Multinomial Logit Demand Firms with varying degrees of risk sensitivity perceive the same stochastic profit prospect differently. It is important to understand the equilibrium pricing behaviors under risk aversion and their implications on firms’ survival and market health. The authors identify a power index, which is the ratio of product attractiveness to risk sensitivity, and show that the set of profitable firms is power index ordered. Firms with a favorable power index value earn a positive profit in a price competition, and others are driven to zero profit. Interestingly, although high risk aversion handicaps a firm, this paper shows that moderate risk aversion may give a firm an advantage over an otherwise equivalent competitor that is less risk sensitive. The authors also establish that in an equilibrium with market entry and exit, the power index is generalized to the ratio of product attractiveness and an entry cost-adjusted risk sensitivity measure.