Loss Aversion Explains Risk Aversion
February 22, 2001
Behavioral science is a key component of economics. One of the primary theories is the diminishing marginal utility of wealth -- that is, individuals value an extra dollar less the richer they become. This theory has been used to explain the observation that people do not like uncertainty, and thus will accept a smaller sum that is a "sure thing" over a possible big win.
For example, people generally prefer a certain $100 rather than a 50-50 chance of receiving $200 or zero dollars. Marginal utility theory seemed to explain this by implying that the utility of the second hundred dollars is less than the first.
But according to behavioral economist Matthew Rabin, this theory is false. Rabin says it becomes apparent that this theory is wrong when it is applied to larger wagers, where it implies the marginal utility of money diminishes at an absurd rate. For example, according to the mathematics behind diminishing utility:
- A person who turns down a potential $100 loss/$101 gain on a 50-50 gamble will also turn down a potential $10,000 loss/$27,780 gain (a significantly better risk).
- This same person will also turn down a $20,000 risk / $85,750 gain on a 50-50 gamble (a fairly good risk), and a potential $1,000 loss/$718,190 gain.
Rabin argues that the reason people are risk adverse is that they are loss averse: they fear losing the value they have more than they are attracted to the possibility of big gains. Rabin says this is a better explanation of loss aversion than the diminishing utility of wealth. Because the diminishing utility theory does not take this into consideration, the loss-to-gain ratios look absurd.
Source: "Risk-Averse or Loss-Averse?" Economic Intuition, Fall 2000; based on Matthew Rabin, "Risk Aversion and Expected Utility Theory: A Calibration Theorem," Econometrica, Vol. 65, Number 5.
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