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Risk aversion and expected utility of consumption over time

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  • Johansson-Stenman, Olof

Abstract

The calibration theorem by Rabin [Rabin, M., 2000a. Risk aversion and expected utility theory: A calibration theorem. Econometrica 68, 1281-1292; Rabin, M., 2000b. Diminishing marginal utility of wealth cannot explain risk aversion. In: Kahneman, D., Tversky, A. (Eds.), Choices, Values and Frames. Cambridge University Press] implies that seemingly plausible small-stake choices under risk imply implausible large-stake risk aversion. This theorem is derived based on the expected utility of wealth model. However, Cox and Sadiraj [Cox, J.C., Sadiraj, V., 2006. Small- and large-stakes risk aversion: Implications of concavity calibration for decision theory. Games Econ. Behav. 56, 45-60] show that such implications do not follow from the expected utility of income model. One may then wonder about the implications for more applied consumption analysis. The present paper therefore expresses utility as a function of consumption in a standard life cycle model, and illustrates the implications of this model with experimental small- and intermediate-stake risk data from Holt and Laury [Holt, C.A., Laury, S.K., 2002. Risk aversion and incentive effects. Amer. Econ. Rev. 92, 1644-1655]. The results suggest implausible risk aversion parameters as well as unreasonable implications for long-term risky choices. Thus, the conventional intertemporal consumption model under risk appears to be inconsistent with the data.

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Bibliographic Info

Article provided by Elsevier in its journal Games and Economic Behavior.

Volume (Year): 68 (2010)
Issue (Month): 1 (January)
Pages: 208-219

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Handle: RePEc:eee:gamebe:v:68:y:2010:i:1:p:208-219

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Web page: http://www.elsevier.com/locate/inca/622836

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Keywords: Expected utility of income Expected utility of final wealth Dynamic consumption theory Asset integration Time inconsistency Narrow bracketing;

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  1. Cox, James C. & Sadiraj, Vjollca, 2006. "Small- and large-stakes risk aversion: Implications of concavity calibration for decision theory," Games and Economic Behavior, Elsevier, vol. 56(1), pages 45-60, July.
  2. Narayana R. Kocherlakota, 1995. "The equity premium: it's still a puzzle," Discussion Paper / Institute for Empirical Macroeconomics 102, Federal Reserve Bank of Minneapolis.
  3. Rabin, Matthew, 2000. "Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion," Department of Economics, Working Paper Series qt61d7b4pg, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  4. Gomes, Francisco J & Michaelides, Alexander, 2005. "Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence," CEPR Discussion Papers 4853, C.E.P.R. Discussion Papers.
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  7. Charles A. Holt & Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, American Economic Association, vol. 92(5), pages 1644-1655, December.
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  15. Johansson-Stenman, Olof, 2009. "Risk Aversion and Expected Utility of Consumption over Time," Working Papers in Economics 351, University of Gothenburg, Department of Economics.
  16. Blundell, Richard & Browning, Martin & Meghir, Costas, 1994. "Consumer Demand and the Life-Cycle Allocation of Household Expenditures," Review of Economic Studies, Wiley Blackwell, vol. 61(1), pages 57-80, January.
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  23. James C. Cox & Vjollca Sadiraj, 2008. "Risky Decisions in the Large and in the Small: Theory and Experiment," Experimental Economics Center Working Paper Series 2008-01, Experimental Economics Center, Andrew Young School of Policy Studies, Georgia State University.
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Cited by:
  1. Johansson-Stenman, Olof, 2009. "Risk Aversion and Expected Utility of Consumption over Time," Working Papers in Economics 351, University of Gothenburg, Department of Economics.
  2. Kerri Brick & Martine Visser & Justine Burns, 2011. "Risk Aversion: Experimental Evidence from South African Fishing Communities," Working Papers 227, Economic Research Southern Africa.
  3. Fafchamps, Marcel & Kebede, Bereket & Zizzo, Daniel John, 2013. "Keep Up With the Winners: Experimental Evidence on Risk Taking, Asset Integration, and Peer Effects," CEPR Discussion Papers 9714, C.E.P.R. Discussion Papers.
  4. Andersson, Fredrik W., 2011. "The lambda model and "rule of thumb" consumers: An estimation problem in existing studies," Journal of Behavioral and Experimental Economics (formerly The Journal of Socio-Economics), Elsevier, vol. 40(4), pages 381-384, August.
  5. Johansson Stenman, Olof & Nordblom, Katarina, 2010. "Are Men Really More Overconfident than Women? - A Natural Field Experiment on Exam Behavior," Working Papers in Economics 461, University of Gothenburg, Department of Economics.
  6. Treffers, T. & Koellinger, Ph.D. & Picot, A.O., 2012. "In the Mood for Risk? A Random-Assignment Experiment Addressing the Effects of Moods on Risk Preferences," ERIM Report Series Research in Management ERS-2012-014-ORG, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.

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