Alternative Approaches to Comparative nth-Degree Risk Aversion

Abstract

Economists have used the risk premium and the probability premium that are revealed through individual choices to compare how risk averse two individuals are. These behavioral, or choice-based, measures of risk aversion – such as the risk premium and the probability premium – are important because they can be used in experimental investigations into individual characteristics like gender, age, or income that affect the strength of risk aversion. Higher- degree risk aversion (e.g. downside risk aversion or prudence) has recently been shown to play critical roles in decision making under uncertainty. Consequently, it is important to study how to measure the strength of higher-degree risk aversion. In working paper 1805, Alternative Approaches to Comparative nth-Degree Risk Aversion, PERC researcher Liqun Liu and co-author William S. Neilson generalize the three main existing behavioral approaches to measuring risk aversion – including the probability premium approach, the risk premium approach, and the comparative statistics approach – to measuring higher-degree risk aversion. Findings show that, within the expected utility framework, behavior patterns in these behavioral approaches to measuring higher-degree risk aversion are equivalent and can be characterized by the same set of conditions on the utility functions.