Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion
Department of Economics, Working Paper Series from Department of Economics, Institute for Business and Economic Research, UC Berkeley
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.
Keywords: risk; aversion (search for similar items in EconPapers)
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Working Paper: Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion (2001)
Working Paper: Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion (2000)
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