Prudence and Precautionary Effort

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 income 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 probabilities of 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 precaution. The analysis establishes an intuitive condition under which prudence increases precaution and another one under which prudence decreases it.