Rabin and Thaler (2001) on Risk Aversion and the Failures of Expected Utility

Matthew Rabin and Richard H. Thaler, “Risk Aversion,” Journal of Economic Perspectives 15(1): 219-232, Winter 2001.

·  In the expected utility (EU) model, risk aversion is equivalent to diminishing marginal utility of income.

·  Any meaningful risk aversion over small stakes is inconsistent with EU maximization, as it requires a crazy unwillingness to take on risk at larger stakes. In other words, EU maximizers must be effectively risk neutral for small stakes, such as those in laboratory experiments. Nonetheless, people display risk aversion at small stakes.

·  Extended warranties and rental car insurance are purchased by many people, though the small stakes (relative to lifetime wealth) and high prices involved imply that they should be unattractive to expected utility maximizers.

·  Small-scale risk averse behavior is consistent with loss aversion, where the status quo is the reference point, and with mental accounting (narrow bracketing), a failure to look at the situation in the bigger picture.

·  Even the money pump argument offers more support for loss aversion and narrow bracketing than for expected utility maximization, as people are not reliably turned into money pumps. They are more likely to purchase those ill-advised warranties, for instance, when the warranties are tied to the purchase of the good itself, thereby promoting an isolated view of the transaction; for most decisions, consumers will not be so misled. An expected utility maximizer who bought such a warranty, however, would then necessarily agree to all sorts of ridiculous purchases.

·  The rate-of-return on stocks (as opposed to bonds, say) seems to be excessive, even though there should be some premium for holding stocks because stocks are riskier than bonds. This “equity premium puzzle” might be due to loss aversion and narrow bracketing. The day-to-day fluctuations in stock prices cause many short-term losses for shareholders. The equity premium comes from the fact that loss-averse investors require compensation to put up with all of the short term (mental accounting) losses.