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What’s in a u?

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Abstract

We revisit the long-lasting debate about the meaning of the utility function used in the standard Expected Utility (EU) model. Despite the common view that EU forces risk aversion and diminishing marginal utility of wealth to be pegged to one another, here we show that this is not the case. Marginal utility for money is an input into risk attitude, but it is not its sole determinant. The attitude towards ‘pure risk’ is also a contributing factor, and it is independent from the former. We discuss several theoretical implications of this result, for the following topics: (i) non-neutral risk attitudes for profit maximizing firms; (ii) risk-aversion over time lotteries in the presence of discounting; (iii) the equity premium puzzle. We also discuss matters of identification: (i) for firms; (ii) via proxies ; (iii) via standard MLE-methods under parametric restrictions; and (iv) cross-context elicitation in multi-dimensional settings, and its relationship with the methods and results from the psychology literature.

Suggested Citation

  • Antonio Penta & Larbi Alaoui, 2025. "What’s in a u?," Economics Working Papers 1909, Department of Economics and Business, Universitat Pompeu Fabra.
    • Handle: RePEc:upf:upfgen:1909
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    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • C92 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Group Behavior
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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