Risk Taking Behavior in the Presence of Nonconvex Asset Dynamics

Abstract

A growing literature on poverty traps emphasizes the links between multiple equilibria and risk avoidance. However, multiple equilibria may also foster risk taking behavior by some poor people. We illustrate this idea with a simple analytical model in which people with different wealth and ability endowments make investment and risky activity choices in the presence of known nonconvex asset dynamics. This model underscores a crucial distinction between familiar static concepts of risk aversion and forward-looking dynamic risk responses to nonconvex asset dynamics. Even when unobservable preferences exhibit decreasing absolute risk aversion, observed behavior may suggest that risk aversion actually increases with wealth near perceived dynamic asset thresholds. Although high ability individuals are not immune from poverty traps, they can leverage their capital endowments more effectively than lower ability types and are therefore less likely to take seemingly excessive risks.

JEL Classification: D81, O12, D90