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Consumption Commitments, Unemployment Durations, and Local Risk Aversion

  • Raj Chetty

Studies of risk preference have empirically established two regularities that are inconsistent with the canonical expected utility model: (1) risk aversion over small gambles greatly exceeds risk aversion over larger stakes and (2) insurance buyers play the lottery. This paper characterizes risk preferences both theoretically and empirically in a world with two consumption goods, one of which involves a commitment in that an adjustment cost must be paid when the good is sold. In this model, utility over wealth is more curved locally than globally: individuals are more risk averse with respect to moderate-scale income fluctuations than they are to large income fluctuations. Commitments also create a gambling motive. The empirical importance of commitments is tested using the labor-supply method of estimating risk aversion of Chetty (2003a). Global curvature is imputed using existing labor supply elasticities, and variations in unemployment insurance laws are used to estimate local curvature in a dynamic job search model. Commitments significantly change preferences over wealth: The local coefficient of relative risk aversion is an order of magnitude larger than the global one. Implications for a broad set of questions such as optimal social insurance policies and portfolio choice are discussed.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10211.

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Date of creation: Jan 2004
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Publication status: published as Raj Chetty & Adam Szeidl, 2007. "Consumption Commitments and Risk Preferences," The Quarterly Journal of Economics, MIT Press, vol. 122(2), pages 831-877, 05.
Handle: RePEc:nbr:nberwo:10211
Note: EFG LS AP PE
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