This article was published in the Journal of Political Economy, 1981, vol. 89 no. 3, p. 600. Webbed with permission.

Why There Are No Risk Preferrers

Somewhat more than 100 years ago, Smith's celebrated diamond-water paradox was solved by the observation that however valuable water might be to someone who had none, if it was produced and sold in unlimited quantities at a price p consumers would adjust their rate of consumption so that its marginal value to them was at most p. The same argument implies that behavior under uncertainty depends not merely on the actor's utility function but also on the cost of producing (and absorbing) risk. However fond I may be of uncertainty, I will not buy it at a high price (by choosing a profession whose returns have high variance but low expected value) when I can get it at a low one (in Las Vegas).

Risk can be produced inexpensively; existing sellers in Las Vegas and elsewhere charge only a few percent of the expected value of the gamble, part of which must be regarded as payment not for the risk itself but for the palatial surroundings in which it is produced. Hence, absent special circumstances (such as a government monopoly of risk production), we may expect individuals in equilibrium to exhibit at most a small degree of risk preference, for the same reason that they exhibit at most a small marginal utility for water.

Insurance, unlike risk, is inherently costly to produce because of the problems of moral hazard. Moral hazard is a major cost of insurance but a minor cost of gambling because a gambling game, being created for the purpose of producing risk, can be designed to almost eliminate the ability of participants to spend resources on influencing the outcome. The seller of insurance faces a preexisting situation in which it is likely that the buyer (of, say, unemployment insurance) can and will affect the odds by his actions. Hence insurance is costly to produce and individuals in eguilibrium may exhibit a substantial degree of risk avoidance.

David Friedman
Virginia Polytechnic Institute

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