Risk aversion, downside risk aversion and paying for stochastic improvements

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Abstract

This paper considers the relationship between risk preferences and the willingness to pay for stochastic improvements. We show that if the stochastic improvement satisfies a double-crossing condition, then a decision maker with utility v is willing to pay more than a decision maker with utility u, if v is both more risk averse and less downside risk averse than u. As the condition always holds in the case of self-protection, the result implies novel characterizations of individuals willingness to pay to reduce the probability of loss. By establishing a general result on the correspondence between an individual's willingness to pay, and his optimal purchase of stochastic improvement when there is a given relationship between stochastic improvements and the amount paid for them, we further show that all results on the willingness to pay can be applied directly to characterize the conditions under which a more risk averse individual will optimally choose to buy more stochastic improvement. Generalizations of existing results on optimal choice of self-protection can be obtained as corollaries. © 2012 The International Association for the Study of Insurance Economics.

Bibliographical metadata

Original languageEnglish
Pages (from-to)1-26
Number of pages25
JournalGENEVA Risk and Insurance Review
Volume37
Issue number1
DOIs
Publication statusPublished - Mar 2012