Financial Conditions and Supply Decisions when Firms are risk averse

Extending earlier work by Greenwald and Stiglitz (1993) on the role of a firm's equity position and bankruptcy costs in determining its production decision we show that, even if bankruptcy costs are ignored, a firm's decision makers' risk aversion, whether they are owner-entrepreneurs or hired managers, can give rise to the same results. What is more, we argue that, in the presence of risk aversion, increased variance of the output price affects a firm's supply decision as the sum of an impact and an indirect effect. Under reasonable assumptions the impact effect prevails and then output decreases. We show this to hold for risk attitudes represented both by CARA and by CRRA utility functions. Finally, we explore the dynamics of the equity base. We provide examples in which the accumulation of net worth slows down as a consequence of an increase of risk.