Risk Effects on Optimal Decision Making – A Question of the Right Order

34 Pages Posted: 22 May 2020

See all articles by Mario Menegatti

Mario Menegatti

University of Parma - Dipartimento di Economia

Richard Peter

University of Iowa

Date Written: April 25, 2020

Abstract

We study risk effects, including higher-order risk effects, on optimal decision making in the linear-payoff model. This model includes the standard portfolio problem, the coinsurance problem, the problem of output choice with a risky price or a risky cost, and the problem of hedging a risky return as special cases. We distinguish between risk taking and risk mitigation and between uncertainty over a benefit and uncertainty over a cost. We identify restrictions on preferences for clear-cut comparative static effects of Nth-degree risk increases. For an uncertain benefit, the decision maker compensates increased risk by lowering exposure to risk; for an uncertain cost, the behavioral response depends on the parity of the order of the risk change. This is because only even-order risk changes increase the riskiness of terminal wealth while odd-order risk changes reduce it. To resolve this discrepancy, we introduce a new class of stochastic dominance relations that is suitable for uncertainty over a cost.

Keywords: higher-order risk, relative risk aversion, comparative statics, decision making

JEL Classification: D61, D81

Suggested Citation

Menegatti, Mario and Peter, Richard, Risk Effects on Optimal Decision Making – A Question of the Right Order (April 25, 2020). Available at SSRN: https://ssrn.com/abstract=3585380 or http://dx.doi.org/10.2139/ssrn.3585380

Mario Menegatti

University of Parma - Dipartimento di Economia ( email )

Via Kennedy 6
Parma, Parma 43100
Italy

Richard Peter (Contact Author)

University of Iowa ( email )

341 Schaeffer Hall
Iowa City, IA 52242-1097
United States

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