The Case Against Power Utility And A Suggested Alternative: Resurrecting Exponential Utility

Utility modeled as a power function is commonly used in the literature despite the fact that it is unbounded and generates asset pricing puzzles. The unboundedness property leads to St. Petersburg paradox issues and indifference to compound gambles, but these problems have largely been ignored. The asset pricing puzzles have been solved by introducing habit formation to the usual power utility. Given these issues, the authors believe it is time re-examine exponential utility. Exponential utility was abandoned largely because it implies increasing relative risk aversion in a cross-section of individuals and non-stationarity of the aggregate consumption to wealth ratio, contradicting macroeconomic data. They propose an alternative preference specification with exponential utility and relative habit formation.