The Output Decision of a Risk-Neutral Producer Under Risk of Liquidation

A risk-neutral producer faces liquidity constraint that forces him to liquidate real assets in imperfect markets if he cannot meet his cash obligation, entailing a fixed liquidation cost. Under this risk of liquidation, the risk-neutral producer is shown to refuse to undertake a risky project with positive expected excess return, exhibiting first-order risk aversion. The optimal output level of the producer is piecewise linear in wealth; it decreases or increases depending on whether the expected excess return is positive or negative. The producer's apparent utility function exhibits an S-shaped curve when the initial liquid assets are affected by a background risk that is normally distributed