David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

12.l Individual attitudes to risk
Such leisure activities form only a trivial part of the risk that we face in our everyday lives. This approach
is unhelpful in thinking about the risk of our house burning down, or the risk a firm takes in building a
new factory. These are not leisure pursuits. Serious money is at stake.
Suppose you are starving and broke. Getting £ 1000 would yield you a lot of utility or happiness, by allowing
you some basic food. If you got another £1000, there are still things to spend it on that you really need.
Clothes and shelter, for example. Having dealt with your immediate needs, the next £1000 is still helpful,
but of less extra value than when you were desperate.
Thus, the marginal utility of the first £1000 is very high. You really needed it. The
marginal utility of the next £1000 is not quite so high. As you get more, the
marginal utility of the extra consumption tends to diminish.
Of course, there are exceptions to this general rule. Some people really want a
yacht, and their utility takes a huge jump when they can finally afford one. But
most of us first spend our money on the things we most need, and get less and less
extra satisfaction out of successive equal increases in our spending power.
People's tastes exhibit a
diminishing marginal
utility. Successive equal rises
in consumption quantities add
less and less to total utility.
You have £11 000 and are offered an equal chance of winning or losing £10 000. This is a fair bet in money
terms since the average profit is £0. But it is not a fair bet in utility terms. Diminishing marginal utility
implies that the extra utility you enjoy if the bet wins, taking your total wealth from £ 11 000 to £21 000, is
much smaller than the utility you sacrifice if the bet loses, taking your wealth from £11 000 to £1000. You
get a few extra luxuries with the £10 000 you might win, but you have to give up almost everything if you
lose and have to survive on only £1000.
A risk-averse person declines a fair bet in money terms. The hypothesis of diminishing marginal utility
implies that, except for the occasional gamble for pure entertainment, people should generally be riskaverse.
They should refuse fair money gambles because they are not fair utility gambles. As we shall see,
this story fits many of the facts.
Two implications of this analysis recur throughout the chapter. First, risk-averse people devote resources to
finding ways to reduce risk. As the booming insurance industry confirms, people will pay to get out of some
of the risks that the environment otherwise forces them to bear. Second, individuals who take over the risk
have to be rewarded for doing so. Many economic activities consist of the more risk-averse bribing the less
risk-averse to take over the risk.
Why play a losing game? The case of
the National Lottery
The UK's original National Lottery game, first introduced in 1994, is based on drawing six balls without
replacement from a stock of 49 balls. The odds on matching all six balls are about 1 in 14 million. Only 45 per
cent of sales revenue is returned as prizes, worse odds than received by a blind punter at a horse race.
Nevertheless, the National Lottery is very popular and represents an important source of revenue for the
government. Moreover, the poorest 20 per cent of the population in the UK account for over a third of all
spending on the National Lottery.
Why do many low-income people buy lottery tickets even though the return from them is so poor? Recent
research has shown that poor people see playing the lottery as their best opportunity for improving their
financial situation, albeit wrongly so. The hope of getting out of poverty encourages people to continue to buy
tickets, even though their chances of stumbling upon a life-changing windfall are nearly impossibly slim and
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