A large, risk neutral firm is considering buying a firm that competes in a perfe

Question

A large, risk neutral firm is considering buying a firm that competes in a perfectly competitive market. The firm produces an output from a single input, coal, with price wc. Each unit of coal produces one unit of C02 . The government is considering taxing CO2, with a tax of t per unit of CO2. Right now, the level of the tax is uncertain. Should the large firm offer more or less with an increase in the risk of the carbon tax t? (Define an increase in risk as a Mean-Preserving-Spread as we have in class). Hint: what happens to the firm’s expected profits as risk increases?

Explanation / Answer

The large firm should offer less with an increase in the risk of the carbon tax t because after the large firm has bought the smaller firm, the large firm itself will have to pay for the carbon tax for the C02 produced even by the smaller firm. Thus, in order to make up for the increased cost at a later date, the large firm should be paying lesser at present.

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