American Economic Review: Insights
ISSN 2640-205X (Print) | ISSN 2640-2068 (Online)
Background Risk and Small-Stakes Risk Aversion
American Economic Review: Insights
vol. 6,
no. 2, June 2024
(pp. 262–76)
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.Citation
Mu, Xiaosheng, Luciano Pomatto, Philipp Strack, and Omer Tamuz. 2024. "Background Risk and Small-Stakes Risk Aversion." American Economic Review: Insights, 6 (2): 262–76. DOI: 10.1257/aeri.20220480Additional Materials
JEL Classification
- D81 Criteria for Decision-Making under Risk and Uncertainty
- D91 Micro-Based Behavioral Economics: Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making