Marginal Utility Versus Bet Hedging

Kevin Drum describes a question he threw out to his readers:

So how to get at the difference? Well, I figured one possible way is this: if you really were a fairly ordinary upper middle class wage earner making $100K per year, and you had a 50-50 chance of either joining the ranks of the elite or falling down to the bottom of the working class [making $30,000 per year, with no chance of improvement or aid from others], which seems further away to you? The answer from comments was loud and clear: the bottom of the working class. I didn’t count, but I’d say only about 10% of commenters were willing to take the coin flip. The other 90% would stick with their $100K lifestyle.

Matthew Yglesias comments:

I actually think Drum is pointing to something profoundly important here, namely that even though a dollar is a dollar the marginal utility associated with an additional dollar of consumption declines pretty sharply.

But I think this is the wrong way to approach the question.

I think what’s going on here is that most people are terrified of being poor, especially in light of the social stigma attached to being lower income. Let’s leave aside the obvious point, that for most U.S. households, $100,000 would be an improvement. Most people are making the calculation that $100,000 annually would be enough, if not fantastic, whereas $30,000 just isn’t enough. It’s not worth the risk.
This isn’t a case of decreasing marginal utility, but bet hedging against an undesirable outcome.
The other point I would raise is ego. Some people, including me, would kick ourselves if we would up on the wrong side of the 50-50 flip. Peace of mind matters too.

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5 Responses to Marginal Utility Versus Bet Hedging

  1. Matthew Platte says:

    I think you all need a reality check: The “bottom of the working class” is nowhere near the $15/hour wage that Mr. Drum suggests, leaving aside the near certainty that Drum’s hundred-thousand-dollar man will have extensive benefits that the real-world worker can only dream of.
    I wanted to end this comment with a snarky “how’s the weather in that ivory tower?” but decided not to. 😉 Heh.

  2. Physicalist says:

    I’m not sure your point is really different from that of Yglesias. Let’s grant that $100K “is enough” and $30K “just isn’t enough.” Doesn’t this imply that $70K is far more valuable for someone at the lower end than it is for someone at the higher end? Sounds like the diminishing marginal utility of money to me.

  3. Ambitwistor says:

    A common error is conflating diminishing marginal utility with risk aversion. They can be related, but are not always. Hard to say what’s going on here without more information.

  4. KevinH says:

    Isn’t everyone here just rehashing prospect theory? It’s been well shown that risk aversion and declining marginal utility can be mathematically equivalent in choice behavior as long as you allow a few free parameters like sloppy computation of very small or large percentages. In fact you need no free parameters to make the choice data in the survey be equivalent because it’s just a single 50/50 shot.
    It sounds like perhaps you are making a psychological argument not an economic one, which as a neuroscientist I’m totally okay with, but there you are dealing with a whole different set of assumptions and terms. We are talking about reward, planning, and a lot of “latent variables” which cannot be answered simply looking at choices. There are plenty of learning and choice models out there and all of them would be able to produce the survey.

  5. Kaleberg says:

    Drum’s whole question was so weird, I couldn’t figure out what he was fishing for even after he explained it. You would expect a little symmetry, at least a constant factor in the incomes. (e.g. $30K, $100K, $300K or $10K, $100K, $1M). People make the decision to forgo $5 for a chance at $5M all the time with those lottery machines. They just get crappier odds.
    Then Drum goes on about people with in income ratio of 1:3:30 as having things in common. Well, they’re all carbon based life forms, but one of them doesn’t have to work for a living. Hint, it’s not Joe Sixpack making $30K a year.
    I just couldn’t figure out if Drum is being dumb or dumber with this.

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