Utility theory and participation in unfair lotteries

Abstract

Since the development of the expected utility maxim by von Neumann and Morgenstern [2], attempts have been made to provide a rational explanation for the observed behavior of individuals under uncertainty. One aspect of such behavior which will concern us in the paper is the willingness of an individual to purchase insurance and lottery tickets. In this connection it has been pointed out that there is an inconsistency between the usual assumption of risk aversion by individuals and their participation in fair and even unfair lotteries. A fair lottery will never be undertaken by an individual with a concave utility function for wealth which implies risk aversion. However, the purchase of insurance is consistent with such a utility function.