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Prudence and preference for flexibility gain

Daniel Danau ()

Economics Working Paper Archive (University of Rennes 1 & University of Caen) from Center for Research in Economics and Management (CREM), University of Rennes 1, University of Caen and CNRS

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.

Keywords: Prudence; Risk aversion; Sequential screening; Real Options (search for similar items in EconPapers)
JEL-codes: D81 (search for similar items in EconPapers)
Date: 2017-03, Revised 2017-11
New Economics Papers: this item is included in nep-mic and nep-upt
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Related works:
Journal Article: Prudence and preference for flexibility gain (2020) Downloads
Working Paper: Prudence and preference for flexibility gain (2020)
Working Paper: Prudence and preference for flexibility gain (2019) Downloads
Working Paper: Prudence and preference for flexibility gain (2018) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:tut:cremwp:2017-05

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