Small economic gambles are insignificant when large background uncertainty is considered | 1/18/2020 | Staff
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The decision to buy a lottery ticket, gamble on a stock, or buy an insurance policy often comes down to an assessment of risk. How much do I have to lose or gain? For centuries, economists have debated about when somebody should take or walk away from a bet. Now, in new research from Caltech and Yale University, economists are weighing in on the conversation with new mathematical arguments that take a person's overall uncertainty in life into account. The results show that when somebody's overall uncertainty—or "background uncertainty"—is large enough compared to a particular small gamble, then the risk of the gamble becomes less significant.

"An old idea we build on is that you should not look at small odds in isolation," says Luciano Pomatto, assistant professor of economics at Caltech and co-author of the new analysis, accepted for publication in the Journal of Political Economy. "In real life, you're never facing choices that are isolated. There is always other risk and other uncertainties that you are facing at the same time."

Background - Risk - Gamble - Example - Volvo

To better understand how background risk can affect a small gamble, consider the following example. Let us say that you drive a beat-up 1995 Volvo station wagon and are wondering if you should buy theft insurance. An insurance policy could protect you against the risk of losing the car, valued at $1,000. According to the authors of the new study, this small risk becomes less pertinent if background risk is high.

"Say you are 22 years old and all you have is this car," says co-author Omer Tamuz, professor of economics and mathematics at Caltech. "Buying insurance in this case makes sense—but not so much if you are in a place in life where bigger things are at stake: your hair is graying out, you start having health problems, and...
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