A correspondent writes:

You may be interested in this article by Matthew Rabin which makes the point that you make in your article: if you are an expected utility maximizer then turning down small actuarially unfair bets (e.g. 50% win $120; 50% lose $100) implies that you would never accept a bet where could lose $1000 (even if you might win an infinite amount of money). (But proved in more generality).

This was taught to me in the first year of my econ phd program (which I’m currently in!) as why you probably don’t want to extrapolate from decisions over small bets to risk aversion in general, not as why we should throw out risk aversion and expected utility maximization completely. Of course, decision theorists do all kinds of things to try to “fix” this problem.

My reply: Yitzhak (as we called him in high school) wrote his paper after mine had appeared; unfortunately my article was in a statistics journal and he had not heard about it. (This was before I could publicize everything on the blog. And, even now, I think a few papers of mine manage to get out there without being noticed.)

I’m glad they teach this stuff in grad schools now–although, in a way, this still proves my point, in that the nonlinear-utility-function-for-money model is still considered such a standard that they feel the need to debunk it.

My correspondent replied: “I wouldn’t call it a debunking….we still go on to use it as the workhorse model in everything we do….”

I think there are good and bad things about this “workhorse model”:

I think utility theory is great, both in theory and even in practice (which is why I devoted a chapter of Bayesian Data Analysis to it). And I have no problem with the study of risk aversion–that is, of the psychological/economic phenomenon of aversion to risk. I also think it’s a good idea to study aversion to loss (not the same thing as risk, for example people don’t seem to even like to lose $10, but that’s hardly a “risk” in the usual sense of the word) and aversion to uncertainty (as in the $20/30/40 example). All three of these phenomena seem interesting to me, and important enough that it’s worth keeping them as three separate concepts. Heck, I even like the game Risk.

But . . . I think that equating risk aversion to the declining utility of money is a mistake that doesn’t help anybody. Given the well-known phenomenon of uncertainty aversion (even apart from loss aversion or risk aversion), I don’t think it makes sense to use people’s preferences over gambles, at whatever scale, to try to assess their utility functions.

I’m sure that there are lots of useful tools that people have for addressing these problems in applied economic analysis; as noted above, my frustration comes from always having to clear the air about risk aversion, uncertainty aversion, etc. I really think the term “risk aversion” does more harm than good, by leading people to think that there’s one single concept that handles all these different psychological/economic phenomena.