On bounded rationality and risk aversion

Experimental evidence suggests that agents who consume at their usual income level are very risk averse, whereas at lower income levels they often become risk loving. This paper provides a theoretical rationale for these experimental results. It shows that bounded rationality increases risk aversion at the reference income level. However, there is a range of lower income levels at which bounded rationality reduces risk aversion. A decision maker is boundedly rational if he, facing a new income, does not ̄nd his new optimal consumption bundle with certainty. This alters his indirect utility function and thus his attitude towards income lotteries. Bounded rationality is modelled in two ways. In the random choice approach the decision maker errs in choosing the new consumption bundle, while in the random utility approach he does not know precisely which bundle is his optimal one.