Tilted Forum Project Discussion Community - View Single Post - Risk Aversion as a reason for income inequality

Scipio · 05-09-2005, 02:22 PM

I would rate utility theory alongside such innovations as elasticity as two of the more important economic ideas that bring the general optimization/equilibrium discipline in line with reality.

Here though, I'll try to keep it brief and simple. Premise: In the United States, and most of the world, the rich (say, the top 5%) get richer, and the lower classes (to throw out another number, the bottom 66%) gain less ground. This is one of the fundamental points of strain in a capitalist system. As long as some kind of balance is struck (the bottom segment gets some of the benefits of society's overall progress), peace and prosperity abide.

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Begin brief economics lesson:

What is risk aversion? It's simple, and here's a basic mathematical example, using expected values and common sense:

Job A: For each month, you have a .05 probability of getting $200,000 dollars, and a .95 probability of getting nothing.

Expected monthly income: $10,000
Expected annual income: $120,000

Job B: You have a 1.0 probablility of getting $5,000 each month.

Expected monthly income: $5000
Expected annual income: $60,000

If people are sufficiently risk averse, they'll take the second option, even though in the long run they'll make twice as much with the first one. Utility theory says that people don't try to maximize money, they try to maximize utility. A common utility function follows:

U = sqrt(W)

U=utility, W=wealth

Uexpected of Job A = 22.36 (sqrt(200k)*.05 + sqrt(0)*.95)
Uexpected of Job B = 70.71 (sqrt(5k)*1)

As our intuition might indicate, the second job is a lot more attractive to most people. Economics lesson over.

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Simple argument: People who have more wealth are better able to behave in a risk neutral way. They can capture higher expected values even if they take losses sometimes. Imagine that Job B is a typical, decent salaried white collar job, and that Job A is that of a stock trader. The worker will get a certain income to cover his needs. If someone already has enough wealth to survive, they can choose Job A and expect to make twice as much income. Because people in the majority (botton 66%) have to be risk averse merely to survive, they are at a significant competitive disadvantage compared to those who begin better off, simply because of their attitudes towards risk.

Policy implications: without some way to minimize this risk, relatively high income inequality is the equilibrium outcome. Because money has diminishing marginal value, there's a social interest in spreading the money around a bit more. It's also good for overall economic health as it promotes strong consumer demand. Centralization of production is still possible, but some ownership would shift to the somewhat wealthier middle class, who could invest in securities and equities. So how is risk aversion minimized? By rewarding risky (high expected value) behavior, and by minimizing the consquences of good risks (high expected value) that fail.

I'll leave the specific policies for a later time. Just thought I'd toss some of what I've learned in economics in.

05-09-2005, 02:22 PM	#1 (permalink)
Scipio Mencken Location: College	Risk Aversion as a reason for income inequality I would rate utility theory alongside such innovations as elasticity as two of the more important economic ideas that bring the general optimization/equilibrium discipline in line with reality. Here though, I'll try to keep it brief and simple. Premise: In the United States, and most of the world, the rich (say, the top 5%) get richer, and the lower classes (to throw out another number, the bottom 66%) gain less ground. This is one of the fundamental points of strain in a capitalist system. As long as some kind of balance is struck (the bottom segment gets some of the benefits of society's overall progress), peace and prosperity abide. ================== Begin brief economics lesson: What is risk aversion? It's simple, and here's a basic mathematical example, using expected values and common sense: Job A: For each month, you have a .05 probability of getting $200,000 dollars, and a .95 probability of getting nothing. Expected monthly income: $10,000 Expected annual income: $120,000 Job B: You have a 1.0 probablility of getting $5,000 each month. Expected monthly income: $5000 Expected annual income: $60,000 If people are sufficiently risk averse, they'll take the second option, even though in the long run they'll make twice as much with the first one. Utility theory says that people don't try to maximize money, they try to maximize utility. A common utility function follows: U = sqrt(W) U=utility, W=wealth Uexpected of Job A = 22.36 (sqrt(200k).05 + sqrt(0).95) Uexpected of Job B = 70.71 (sqrt(5k)*1) As our intuition might indicate, the second job is a lot more attractive to most people. Economics lesson over. ================ Simple argument: People who have more wealth are better able to behave in a risk neutral way. They can capture higher expected values even if they take losses sometimes. Imagine that Job B is a typical, decent salaried white collar job, and that Job A is that of a stock trader. The worker will get a certain income to cover his needs. If someone already has enough wealth to survive, they can choose Job A and expect to make twice as much income. Because people in the majority (botton 66%) have to be risk averse merely to survive, they are at a significant competitive disadvantage compared to those who begin better off, simply because of their attitudes towards risk. Policy implications: without some way to minimize this risk, relatively high income inequality is the equilibrium outcome. Because money has diminishing marginal value, there's a social interest in spreading the money around a bit more. It's also good for overall economic health as it promotes strong consumer demand. Centralization of production is still possible, but some ownership would shift to the somewhat wealthier middle class, who could invest in securities and equities. So how is risk aversion minimized? By rewarding risky (high expected value) behavior, and by minimizing the consquences of good risks (high expected value) that fail. I'll leave the specific policies for a later time. Just thought I'd toss some of what I've learned in economics in. __________________ "Erections lasting more than 4 hours, though rare, require immediate medical attention."