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Background Risk and Small-Stakes Risk Aversion

Author

Listed:
  • Xiaosheng Mu

    (Princeton University)

  • Luciano Pomatto

    (Caltech)

  • Philipp Strack

    (Yale University)

  • Omer Tamuz

    (Caltech)

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, 2023. "Background Risk and Small-Stakes Risk Aversion," Working Papers 2021-26, Princeton University. Economics Department..
    • Handle: RePEc:pri:econom:2021-26
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    More about this item

    Keywords

    risk; theories of choice;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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