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Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion

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Author Info
Matthew Rabin (Economics Department, University of California, Berkeley)
Abstract

Arrow (1971) shows that an expected-utility maximizer with a differentiable utility function will always want to take a sufficiently small stake in any positive-expected-value bet. That is, expected-utility maximizers are arbitrarily close to risk neutral when stakes are arbitrarily small. While most economists understand this formal limit result, fewer appreciate that the approximate risk-neutrality prediction holds not just for very small stakes, but for quite sizable and economically important stakes. Diminishing marginal utility of wealth is not a plausible explanation of people's aversion to risk on the scale of $10, $100, $1000 or even more. After illustrating and providing intuition for these claims, I shall argue that economists often reach misleading conclusions by invoking expected-utility theory to explain substantial risk aversion in contexts where the theory actually predicts virtual risk neutrality.

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Paper provided by Department of Economics, Institute for Business and Economic Research, UC Berkeley in its series Department of Economics, Working Paper Series with number 1025.

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Date of creation: 09 Jun 2000
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Handle: RePEc:cdl:econwp:1025

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Keywords: risk aversion;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Kahneman, Daniel & Knetsch, Jack L & Thaler, Richard H, 1991. "The Endowment Effect, Loss Aversion, and Status Quo Bias: Anomalies," Journal of Economic Perspectives, American Economic Association, vol. 5(1), pages 193-206, Winter. [Downloadable!] (restricted)
  2. N. Gregory Mankiw & Stephen P. Zeldes, 1991. "The Consumption of Stockholders and Non-Stockholders," NBER Working Papers 3402, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  3. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March. [Downloadable!] (restricted)
  4. Benartzi, Shlomo & Thaler, Richard H, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 73-92, February. [Downloadable!] (restricted)
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  5. Machina, Mark J, 1987. "Choice under Uncertainty: Problems Solved and Unsolved," Journal of Economic Perspectives, American Economic Association, vol. 1(1), pages 121-54, Summer. [Downloadable!] (restricted)
  6. Gneezy, Uri & Potters, Jan, 1997. "An Experiment on Risk Taking and Evaluation Periods," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 631-45, May.
  7. Loomes, Graham & Segal, Uzi, 1994. "Observing Different Orders of Risk Aversion," Journal of Risk and Uncertainty, Springer, vol. 9(3), pages 239-56, December.
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  8. Epstein, Larry G. & Zin, Stanley E., 1990. "'First-order' risk aversion and the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 387-407, December. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. David H. Krantz & Howard Kunreuther, 2006. "Goals and Plans in Protective Decision Making," NBER Working Papers 12446, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Livio Stracca & Ali Al-Nowaihi, 2002. "Non-standard Central Bank loss functions; skewed risks; and certainty equivalence," Working Paper Series 129, European Central Bank. [Downloadable!]
  3. Paul Heidhues & Botond Köszegi, 2004. "The Impact of Consumer Loss Aversion on Pricing," CIG Working Papers SP II 2004-17, Wissenschaftszentrum Berlin (WZB), Research Unit: Competition and Innovation (CIG). [Downloadable!]
    Other versions:
  4. Botond Koszegi & Matthew Rabin, 2004. "A Model of Reference-Dependent Preferences," Department of Economics, Working Paper Series 1061, Department of Economics, Institute for Business and Economic Research, UC Berkeley. [Downloadable!]
  5. David H. Krantz & Howard C. Kunreuther, 2007. "Goals and plans in decision making," Judgment and Decision Making, Society for Judgment and Decision Making, vol. 2, pages 137-168, June. [Downloadable!]
  6. repec:bep:eapadv:v:8:y:2008:i:1:p:1798-1798 is not listed on IDEAS
  7. Rulon Pope & Jeffrey LaFrance & Richard E. Just, 2007. "Agricultural Arbitrage and Risk Preferences," Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series 1041, Department of Agricultural & Resource Economics, UC Berkeley. [Downloadable!]
    Other versions:
  8. Matthew Rabin & Richard H. Thaler, 2001. "Anomalies: Risk Aversion," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 219-232, Winter. [Downloadable!] (restricted)
  9. Botond Koszegi & Matthew Rabin, 2004. "A Model of Reference-Dependent Preferences," Method and Hist of Econ Thought 0407001, EconWPA. [Downloadable!]
  10. Fabrizio Botti & Anna Conte & Daniela T. Di Cagno & Carlo D'Ippoliti, . "Risk attitude in real decision proBLEMs," Quaderni DPTEA 144, Department of Economic and Business Sciences, LUISS Guido Carli. [Downloadable!]
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