Can Expected Utility Theory Explain Gambling?
We investigate the ability of expected utility theory to account for simultaneous gambling and insurance. Contrary to a previous claim that borrowing and lending in perfect capital markets rules out a demand for gambles, we show that expected utility theory with non-concave utility functions can still explain gambling. When the rates of interest and time preference are equal, agents will seek to gamble unless income falls in a finite set of exceptional values. When these rates differ, there will be a range of incomes for which gambles are desired. In both cases repeated gambling is not explained but market imperfections such as different borrowing and lending rates can account for persistent gambling provided the rates span the rate of time preference.
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