Prudence and Precautionary Effort

• Date: 01 March 2019
• Published date: 01 March 2019
• DOI: http://doi.org/10.1111/jori.12204
• Author: Kangoh Lee

©2017 The Journal of Risk and Insurance. Vol.86, No. 1, 151–163 (2019).

DOI: 10.1111/jori.12204

Prudence and Precautionary Effort

Kangoh Lee

Abstract

It is well known that prudence increases precautionary effort in the presence

of future uncertain income. This result is intuitive, as prudent individuals

take more caution to reduce the probability of accident in response to in-

come uncertainty.However, this known result holds true only in a two-state

model with either a loss or no loss occurring. With more than two states

of the world, losses of different magnitudes occur, and precautionary effort

may not reduce the probabilitiesof all losses. The effect of income uncertainty

on precautionary effort hinges on how it affects the probability distribution

of losses, and prudence is neither necessary nor sufficient for more precau-

tion. The analysis establishes an intuitive condition under which prudence

increases precaution and another one under which prudence decreases it.

Introduction

The notion of risk aversion has been firmly established in economics, finance, and

psychology,but higher-order risk preferences such as prudence and temperance have

received a good deal of attention only recently (Deck and Schlesinger,2010; Ebert and

Wiesen, 2014; Noussair, Trautmann, and Van De Kuilen, 2014). Such preferences play

an important role in the analysis of various issues related to risk and uncertainty.

For instance, prudent individuals increase their saving when their future income

becomes uncertain, but imprudent individuals decrease their saving (Kimball, 1990,

Guiso, Jappelli, and Terlizzese, 1992; Gollier, 2001, Chap. 16; Giles and Yoo, 2007;

Hurst et al., 2010; Crainich, Eeckhoudt, and Trannoy, 2013).

More recently, a literature has extended saving decisions to precautionary effort (self-

protection or prevention) decisions, and has shown that prudent individuals increase

precautionary effort to reduce the probability of loss when their future income be-

comes uncertain (Eeckhoudt, Huang, and Tzeng, 2012; Nocetti, 2015; Wang and Li,

2015). This literature departs from the existing literature on prevention in an im-

portant way.Since the inception of the idea of prevention, namely self-insurance and

self-protection, by Ehrlich and Becker (1972), the existing literature has studied the de-

cisions to invest in prevention in one-period models. For instance, regardingprudence

or income uncertainty,Eeckhoudt and Gollier (2005) study the effects of prudence on

Kangoh Lee is in the Department of Economics, San Diego State University. Lee can be con-

tacted via e-mail: klee@mail.sdsu.edu. I am grateful to a co-editor of the journal for his helpful

comments that improved the article significantly.

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