@Student
First of all, we don’t have fixed uses for money. The opportunities we have for investing any income we have change with time, so it’s natural that our perception of utility of income adapts to these changing conditions.
But what is important to keep in mind is that the concept of utility function optimization is a very stylized model for how humans take decisions.
Individual utility functions are never directly observable, they are inferred by something called “revealed preferences”, that is, the patterns of decision taking that an individual engage.
In real life some decisions are taken “sequentially” and others follow a “set and go” procedure. “Set and go” decisions are those where all the optimization is done with information available before the action starts. Once the initial decision is made, there’s no more coming back. “Sequential” decisions are those decisions that are taken in a step by step process, each decisional step using the bits of information that unfolded up until it.
Decisions can be also of “incremental” or “yes/no (or discrete)” types. “Incremental” decisions are those that allow for arbitrarily small changes in a spectrum of choices. “Discrete” decisions are those where only a certain number of options are open, and there are no compromise positions between them.
Another important distinction among decisions is the “private” or “public” character of the information being used by the decision maker, when he interacts with other decision makers.
And finally, there’s the “time factor”. Some decisions can be planned very carefully and time itself is not a very scarce resource to be economized in the process. Other decisions might need urgent solutions, even if better alternatives could be found after more deliberation.
There are other categorical distinctions between decisions, but those above are perhaps the most relevant here, so we will restrict ourselves to them.
The assumption of a concave utility function is very consistent to the behavior observed when decision takers face decisions that are “set and go”, “incremental”, based on “public information” and with abundant time for deliberation. Let’s call this kind of decision “regular”.
That’s because the optimization procedure is very simple: you invest the next unit of money to the best yet unsatisfied alternative, and you keep doing that until you’re done.
Since every investing decision is incremental, all information is available before hand, and the decision maker has access to the same information as the observer of the decision maker behavior, Here the decision taker is always in condition to increment the opportunity that is the best marginally.
The “revealed preferences” profile of his inferred utility function will look concave, as his returns diminish after each dollar is spent.
However, if the decision making process is not “regular”, the “revealed preferences” will generally show inconsistencies with a concave utility profile.
For instance, if you happen to know privately that a certain game is rigged, or maybe that you’re privileged with a mysterious lucky factor when playing crabs (your “private information”), your revealed behavior might be inconsistent with risk aversion feature of concave utility functions.
And similarly, if decision making time is limited, if alternatives are limited, etc. That’s why I was talking about owing money to gangsters, or having some medical condition, or some once-in-a-life-time oportunity of investment. All these situations disrupt the regularity of your decision making process, and thus your profile of utility.
Also, somewhat related to the discussion above, is the pricing of options. Options are like bets, they pay you a random amount of money that depends on certain observable events in the market. Theoretically they should have a value according to the players utily function/risk preferences. But since options and the underlying assets are tradeable and since there are no-oportunities of arbitrage, and decisions can be updated, their price does not depend on individual utility function profiles. One can show (it’s quite technical though) that under certain regularity assumptions there’s a probability measure where the market price is given by the expectation, with no risk premium.
The best book about these distinctions in decision making is “Knowledge and Decisions” by Thomas Sowell. This book (like most Sowell’s books) is not likely to be particularly distasteful to austrianites, since it is actually based on the paper “The use of knowledge in society”, by Hayek.
Another good book I recommend that deals with similar problems is Vernon Smith’s “Rationality in Economics”. This book looks a bit more technical than Sowell’s (in the neoclassical sense of having equations and such), but it actually provides a very good conciliation between Hayek’s and Simon’s approaches to decision making.
Also, as you’ve said, there is a lot of material on behavioral economics showing these reveled preferences “violations” of rational expectations assumptions. One that is particularly accessible is “Predictably Irrational” by Dan Arieli. This book, on the other hand, will be very hard to swallow by hardcore austrians.