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, $u^{'''}\left(x\right)>0$ .

The strength of the precautionary saving motive can be measured by absolute prudence, which is defined as $-\frac{u^{'''}\left(x\right)}{u^{''}\left(x\right)}$ . 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.

Famous quotes containing the words prudence in, prudence and/or economics:

“The one prudence in life is concentration; the one evil is dissipation: and it makes no difference whether our dissipations are coarse or fine; property and its cares, friends and a social habit, or politics, or music, or feasting. Everything is good which takes away one plaything and delusion more, and drives us home to add one stroke of faithful work.”
—Ralph Waldo Emerson (1803–1882)

“Men do not fail commonly for want of knowledge, but for want of prudence to give wisdom the preference.”
—Henry David Thoreau (1817–1862)

“The animals that depend on instinct have an inherent knowledge of the laws of economics and of how to apply them; Man, with his powers of reason, has reduced economics to the level of a farce which is at once funnier and more tragic than Tobacco Road.”
—James Thurber (1894–1961)