An Arrow-Pratt Theory of Preference for Early Resolution of Uncertainty

Abstract

This paper develops a theory of the elasticity of preference for early resolution of uncertainty (PER) that parallels the Arrow-Pratt measure of risk aversion in expected utility theory. We demonstrate that the local welfare gain of early resolution of uncertainty is equal to the product of the elasticity of PER and the conditional variance of continuation utility. We illustrate how asset market data can be used to estimate the elasticity of PER and how this measure can be used to compute the welfare gain for various experiments of early resolution of uncertainty.

Keywords: Preference for early resolution of uncertainty, risk aversion, generalized risk sensitivity, elasticity, long-run risk