Professor of Finance
2005 Europlace Institute of Finance
The author investigates, with an approximation, a Grossman-Stiglitz economy under general preferences, thus allowing for wealth effects. Because information generates increasing returns, decreasing absolute risk aversion, in conjunction with the availability of costly information, are sufficient to explain why wealthier households invest a larger fraction of their wealth in risky assets. One no longer needs to resort to decreasing relative risk aversion, an empirically questionable assumption.Furthermore, the author shows how to distinguish empirically between these two explanations. The author then concludes by finding that the availability of costly information exacerbates wealth inequalities.