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Prudence and preference for flexibility gain

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  • Daniel Danau

    (University of Caen Normandy, CREM-CAEN, UMR CNRS 6211, France)

Abstract

Under the expected utility paradigm, prudence (u''' > 0) is usually associated with the amount of risk premium an individual requires in order to renounce to a certain current outcome in favour of an uncertain future outcome. A prudent individual requires a higher premium the lower her initial wealth. However, when the individual has to make a costly investment before obtaining the outcome, she may prefer to delay that investment. This translates into a preference for latter, not earlier outcome. Consequently, prudence cannot be associated with a risk premium. In this paper we show that, for an individual who prefers to delay the investment, prudence is actually associated with the economic bene t granted by that delay. Speci cally, a lower expected unit cost of acquiring the good is associated with a greater bene t of the investment delay if and only if u''' is high, and, with a uniform distribution, u''' > 0. We also show that the preference for facing a lower expected unit cost and/or a wider support of the unit cost increases with u'''. We describe two applications of this result, namely, sequential learning in the delegation of a task and timing of investment decisions under multiperiod uncertainty.

Suggested Citation

  • Daniel Danau, 2017. "Prudence and preference for flexibility gain," Economics Working Paper Archive (University of Rennes 1 & University of Caen) 2017-05, Center for Research in Economics and Management (CREM), University of Rennes 1, University of Caen and CNRS, revised Nov 2017.
  • Handle: RePEc:tut:cremwp:2017-05
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    Keywords

    Prudence; Risk aversion; Sequential screening; Real Options;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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