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Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion

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  • Rabin, Matthew

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.

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  • Rabin, Matthew, 2000. "Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion," Department of Economics, Working Paper Series qt61d7b4pg, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
    • Handle: RePEc:cdl:econwp:qt61d7b4pg
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