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Disentangling Intertemporal Substitution and Risk Aversion under the Expected Utility Theorem

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  • Lau, Chi-Lei Oscar

Abstract

A disturbing feature of the conventional objective function for intertemporal decisions under uncertainty is that the agent's attitudes toward intertemporal substitution and risk aversion are entangled. This paper shows that, in contrast to common perception, the two attitudes can be completely disentangled under the expected utility theorem (EUT) by modeling each of them successively in two steps. The conventional form is nested as a special case where the functions describing the two attitudes are identical. The proposed framework requires only the standard axioms of the EUT, in addition to a regulatory assumption. It is flexible in accommodating different combinations of the two attitudes, indifferent to the timing of resolution of uncertainty, intuitive to interpret, and extendable to multiple goods. The objective function under the proposed framework is time inconsistent according to Strotz's (1955) definition. I argue that Strotz's notion of time consistency is misguided. It is constructed based on a priori assumption that the agent should continuously forget history as time progresses. But this means the agent is either chronically amnesiac or self-contradictory. To be truly consistent, the agent should have one and only one objective function, determined at birth, throughout his entire life. As history unfolds, the agent updates his information set, but not his objective function.

Suggested Citation

  • Lau, Chi-Lei Oscar, 2008. "Disentangling Intertemporal Substitution and Risk Aversion under the Expected Utility Theorem," MPRA Paper 11482, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:11482
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    File URL: https://mpra.ub.uni-muenchen.de/11482/1/MPRA_paper_11482.pdf
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1995. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc.
    3. R. H. Strotz, 1955. "Myopia and Inconsistency in Dynamic Utility Maximization," Review of Economic Studies, Oxford University Press, vol. 23(3), pages 165-180.
    4. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    5. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-543, June.
    6. Chris Starmer, 2000. "Developments in Non-expected Utility Theory: The Hunt for a Descriptive Theory of Choice under Risk," Journal of Economic Literature, American Economic Association, vol. 38(2), pages 332-382, June.
    7. Martin J. Beckmann, 1959. "A Dynamic Programming Model of the Consumption Function," Cowles Foundation Discussion Papers 68, Cowles Foundation for Research in Economics, Yale University.
    8. Robert B. Barsky & F. Thomas Juster & Miles S. Kimball & Matthew D. Shapiro, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, Oxford University Press, vol. 112(2), pages 537-579.
    9. George Loewenstein & Drazen Prelec, 1992. "Anomalies in Intertemporal Choice: Evidence and an Interpretation," The Quarterly Journal of Economics, Oxford University Press, vol. 107(2), pages 573-597.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Intertemporal substitution; Risk aversion; Expected utility theorem; Time consistency; Equity premium puzzle;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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