Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion

Matthew Rabin
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Matthew Rabin: University of California, Berkeley

Game Theory and Information from EconWPA

Abstract: 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.

JEL-codes: C7 D8 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ias
Date: 2001-01-05
Note: 11 pages, Acrobat .pdf
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpga:0012002

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