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Improving the Risk Concept: A Revision of Arrow-Pratt Theory in the Context of Controlled Dynamic Stochastic Environments

  • DAN PROTOPOPESCU

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    In the literature on risk, one generally assume that uncertainty is uniformly distributed over the entire working horizon, when the absolute risk-aversion index is negative and constant. From this perspective, the risk is totally exogenous, and thus independent of endogenous risks. The traditional measures of risk-aversion are generally too weak for making comparisons between risky situations. This can be highlighted in concrete problems in finance and insurance, context for which the Arrow-Pratt measures of risk-aversion give ambiguous results (Ross 1981). We improve the Arrow-Pratt approach (1964, 1971a, 1971b), which takes into account only attitudes towards small exogenous risks, by integrating in the analysis potentially high endogenous risks that are under the control of the agent. Based on multiple theoretical and empirical arguments, this new approach offers an elegant study of the close relationship between behavior, attitude and perceived risk.

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    Paper provided by Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC) in its series UFAE and IAE Working Papers with number 727.08.

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    Length: 43
    Date of creation: 15 Dec 2007
    Date of revision: 03 Dec 2009
    Handle: RePEc:aub:autbar:727.08
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    1. repec:ner:tilbur:urn:nbn:nl:ui:12-364325 is not listed on IDEAS
    2. Kiefer, Nicholas M & Nyarko, Yaw, 1989. "Optimal Control of an Unknown Linear Process with Learning," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(3), pages 571-86, August.
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    4. Stigler, George J & Becker, Gary S, 1977. "De Gustibus Non Est Disputandum," American Economic Review, American Economic Association, vol. 67(2), pages 76-90, March.
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    9. van der Ploeg, Frederick, 1992. "Temporal risk aversion, intertemporal substitution and Keynesian propensities to consume," Economics Letters, Elsevier, vol. 39(4), pages 479-484, August.
    10. repec:cup:cbooks:9780521386975 is not listed on IDEAS
    11. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279.
    12. Matthew Rabin & Richard H. Thaler, 2001. "Anomalies: Risk Aversion," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 219-232, Winter.
    13. Varian, Hal R., 1990. "Goodness-of-fit in optimizing models," Journal of Econometrics, Elsevier, vol. 46(1-2), pages 125-140.
    14. Ross, Stephen A, 1981. "Some Stronger Measures of Risk Aversion in the Small and the Large with Applications," Econometrica, Econometric Society, vol. 49(3), pages 621-38, May.
    15. Gilboa, Itzhak, 1989. "Expectation and Variation in Multi-period Decisions," Econometrica, Econometric Society, vol. 57(5), pages 1153-69, September.
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