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  5. Background Risk and Small-Stakes Risk Aversion

Background Risk and Small-Stakes Risk Aversion

  • Xiaosheng Mu
  • Luciano Pomatto
  • Philipp Strack
  • Omer Tamuz
American Economic Review: Insights (Forthcoming)

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.

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