Risk aversion and expected-utility theory: A calibration theorem

Within the expected-utility framework, the only explanation for risk aversion is that the utility function for wealth is concave: A person has lower marginal utility for additional wealth when she is wealthy than when she is poor. This paper provides a theorem showing that expected-utility theory is an utterly implausible explanation for appreciable risk aversion over modest stakes: Within expected-utility theory, for any concave utility function, even very little risk aversion over modest stakes implies an absurd degree of risk aversion over large stakes. Illustrative calibrations are provided. Keywords: Diminishing Marginal Utility, Expected Utility, Risk Aversion JEL Classifications: B49, D11, D81…

• NS
  National Science Foundation

  Award: 9709485