12. Risk and Inequality

This chapter introduces risk aversion, a departure from previous assumptions of risk-neutrality. It models risk aversion by representing expected payoffs as a "good" and risk exposure as a "bad," a more general approach than restricting it solely to diminishing marginal utility of income. The chapter explores how various costly actions or policies, including linear taxes proportional to realized income, can function as forms of insurance to reduce an individual's level of risk exposure.

Problems in this chapter illustrate how risk aversion influences individual choices, such as a farmer's harvest strategy or a student's education path. They also address the societal implications of risk, particularly in the context of financing public goods like education. The chapter demonstrates that egalitarian redistribution, through linear taxes and lump-sum transfers, can paradoxically decrease risk exposure and thereby increase risk-taking, even with constant or decreasing absolute risk aversion, challenging the notion of an "equality-efficiency trade-off".