Assessment of Simple Joint Time/Risk Preference Functions

In choices between consumption and investment the consumer's objective is to maximize the expected utility of lifetime consumption. This paper outlines a procedure for constructing cardinal utility functions which capture both a consumer's willingness to trade off consumption between years and his attitude toward bearing risk. Simple but flexible utility functions are specified uniquely by mathematically combining the results of three straightforward assessment tasks. The information to be assessed from the consumer is: (1) A preferred consumption pattern for an appropriate lifetime consumption budget. (2) A coefficient of consumption variation aversion. (3) A coefficient of risk aversion with respect to constant annual equivalent consumption outcomes. The consumer performs the first two tasks under deterministic conditions. Uncertainty is introduced in the last step. The advantage of this encoding procedure is the separation of deterministic trade offs and risk preference assessment into tractable, concrete subtasks. The major contribution of this paper is the introduction of a local preference parameter with global implications similar to Pratt's risk aversion coefficient. The local parameter, called consumption variation aversion, is a measure of a consumer's attitude toward undesirable variations in the future consumption pattern. If the preference function V(c) is additive then constant variation aversion implies V(c) is a sum of exponential terms. If variation aversion is inversely proportional to consumption then V(c) is a polynomial with positive exponents. Members of these function families are simple yet they provide great flexibility in describing preferences.