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Background Risk and Small-Stakes Risk Aversion

Author

Listed:
  • Xiaosheng Mu
  • Luciano Pomatto
  • Philipp Strack
  • Omer Tamuz

Abstract

Building on Pomatto, Strack, and Tamuz (2020), we identify a tight condition for when background risk can induce first-order stochastic dominance. Using this condition, we show that under plausible levels of background risk, no theory of choice under risk can simultaneously satisfy the following three economic postulates: (i) decision-makers are risk averse over small gambles, (ii) their preferences respect stochastic dominance, and (iii) they account for background risk. This impossibility result applies to expected utility theory, prospect theory, rank-dependent utility, and many other models.

Suggested Citation

  • Xiaosheng Mu & Luciano Pomatto & Philipp Strack & Omer Tamuz, 2024. "Background Risk and Small-Stakes Risk Aversion," American Economic Review: Insights, American Economic Association, vol. 6(2), pages 262-276, June.
    • Handle: RePEc:aea:aerins:v:6:y:2024:i:2:p:262-76
    DOI: 10.1257/aeri.20220480
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    More about this item

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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