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Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion

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  • Matthew Rabin.

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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Bibliographic Info

Paper provided by University of California at Berkeley in its series Economics Working Papers with number E00-287.

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Date of creation: 01 Jun 2000
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Handle: RePEc:ucb:calbwp:e00-287

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