Logo image
Back
Precaution with multiple instruments: The importance of substitution effects
Journal article   Peer reviewed

Precaution with multiple instruments: The importance of substitution effects

Christoph Heinzel and Richard Peter
Journal of economic behavior & organization, Vol.207, pp.392-412
03/2023
DOI: 10.1016/j.jebo.2023.01.004
url
https://hal.inrae.fr/hal-04356291/documentView
Open Access

Abstract

•Precautionary saving, self-protection and self-insurance under recursive utility.•Unifying result for precautionary behavior in single-instrument cases.•Substitution effects arise when two or more instruments are used.•Substitution effects can dominate the precautionary effect of income risk.•Precautionary disinvestment possible for decision-makers who are prudent otherwise. Using a unified approach, we show how precautionary saving, self-protection and self-insurance are jointly determined by risk preferences and the preference over the timing of uncertainty resolution. We provide a general result when decision-makers use a single instrument at a time. When multiple instruments are used simultaneously, substitution effects arise which attenuate precaution. A numerical analysis demonstrates that these substitution effects can dominate the precautionary effect. For plausible risk and time preference parameters and empirically relevant income risk levels, substitution effects can lead to precautionary disinvestment in self-protection and even crowd out the demand for self-protection entirely. In this case, what looks like lack of precautionary behavior at the surface might not be indicative of lack of prudence but simply be the result of omitted-instrument bias.
 Precaution Prudence Recursive preferences Self-insurance Self-protection Substitution effects

Details

Metrics

24 Record Views
3 Times Cited - Web of Science
Logo image