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Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion

  • Matthew Rabin.

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 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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  1. Uzi Segal & Avia Spivak, 1988. "First Order Versus Second Order Risk Aversion," UCLA Economics Working Papers 540, UCLA Department of Economics.
  2. Thaler, Richard H, et al, 1997. "The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 647-61, May.
  3. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  4. 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.
  5. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc.
  6. Harless, David W & Camerer, Colin F, 1994. "The Predictive Utility of Generalized Expected Utility Theories," Econometrica, Econometric Society, vol. 62(6), pages 1251-89, November.
  7. Mankiw, N. Gregory & Zeldes, Stephen P., 1991. "The consumption of stockholders and nonstockholders," Journal of Financial Economics, Elsevier, vol. 29(1), pages 97-112, March.
  8. Kandel, S. & Stambaugh, R.F., 1990. "Asset Returns, Investment Horizons, And Intertemporal Preferences," Weiss Center Working Papers 7-90, Wharton School - Weiss Center for International Financial Research.
  9. Graham Loomes & Uzi Segal, . "Observing Different Orders of Risk Aversion," Discussion Papers 92/5, Department of Economics, University of York.
  10. Gneezy, U. & Potters, J.J.M., 1996. "An experiment on risk taking and evaluation periods," Discussion Paper 1996-61, Tilburg University, Center for Economic Research.
  11. 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.
  12. Read, Daniel & Loewenstein, George & Rabin, Matthew, 1999. "Choice Bracketing," Journal of Risk and Uncertainty, Springer, vol. 19(1-3), pages 171-97, December.
  13. Daniel Kahneman & Dan Lovallo, 1993. "Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking," Management Science, INFORMS, vol. 39(1), pages 17-31, January.
  14. Daniel Kahneman & Jack L. Knetsch & Richard H. Thaler, 1991. "Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias," Journal of Economic Perspectives, American Economic Association, vol. 5(1), pages 193-206, Winter.
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