Generalized Fairness Preferences and Risk-Sharing Across Generations
University of Washington - Department of Finance and Business Economics
Christopher M. Hrdlicka
University of Washington - Michael G. Foster School of Business
February 4, 2014
Leaders' preferences for fairness determine how they divide a stochastic surplus across generations and how much risk they take with this surplus. We generalize Rawlsian and utilitarian models of fairness preferences to a stochastic setting, nesting these previous models and separating the preferences for fairness across states and dates from those for risk aversion and intertemporal elasticity of substitution. This flexible parametrization allows us to model a wide range of preferences for fairness, which we apply to endowed funds (sovereign, non-profit, university), public pension plans, and the depletion of natural resources in the context of global warming. We find that a stronger preference for stochastic fairness generates lower risk taking and a lower but more stable growth path for the social surplus. Combined with the fact that a project's discount rate depends on its riskiness, our model rationalizes why leaders choose low discount rates when analyzing projects that span many generations. Indeed, it is their fairness-driven preferences that makes them choose safer projects, which, in turn, require the use of low discount rates. Similarly, fairness preferences explain why leaders act conservatively, e.g., in the case of climate policies, when imposing risk on others even though they, and their constituents, may have low risk aversion. Lastly, our model highlights a tension between the preference for intergenerational fairness and mandates for high payouts, e.g., in the case of public pension plans, to the current generation.
Number of Pages in PDF File: 62
Keywords: Fairness, intergenerational equity, risk-sharing, portfolio choice, endowments, public pension plans, global warming
JEL Classification: E61, D63, D78, H55, H43, Q32, Q56, G11
Date posted: June 2, 2012 ; Last revised: February 5, 2014
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