Prudence - Prudence in Economics

Prudence in Economics

Economists say that a consumer is 'prudent' if he or she saves more when faced with riskier future income. This additional saving is called precautionary saving. Prudence is closely related to risk aversion. The difference is that saying a consumer is risk averse merely implies that he or she dislikes facing risk, whereas prudence implies that the consumer takes action to offset the effects of the risk (namely, by increasing saving).

If a risk averse consumer has a utility function over consumption x, and if is differentiable, then the consumer is not prudent unless the third derivative of utility is positive, that is, .

The strength of the precautionary saving motive can be measured by absolute prudence, which is defined as . Similarly, relative prudence is defined as absolute prudence, multiplied by the level of consumption. These measures are closely related to the concepts of absolute and relative risk aversion developed by Kenneth Arrow and John W. Pratt.