Modeling Risk Aversion in Economics

Abstract

To capture the risk-aversion intuition, the standard approach in economics has been to utilize the model of expected utility, in which risk aversion derives from diminishing marginal utility for wealth (or diminishing marginal utility for aggregate consumption). The expected utility model for risk aversion has been used to derive many important insights. But over the years, economists and psychologists have identified various problematic issues with expected utility as a descriptive model of choice. In this article, we urge economists to take seriously the research agenda of developing and assessing different ways to model risk aversion. We proceed in three main steps. First, we highlight that the basic intuition of risk aversion that drives many results in economics is not intimately tied to expected utility. Second, we describe a few alternative models that can also capture the basic intuition of risk aversion. Finally, we discuss that, while expected utility and the alternative models might all capture the basic intuition of risk aversion, the alternative models can generate additional, more nuanced implications not shared with expected utility, that in some cases seem to be borne out by data. We emphasize that these alternative models also are not perfect, and further research is needed to identify even better approaches.