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Risk Aversion and Expected-Utility Theory: A Calibration Theorem
Abstract
Within the expected-utility framework, the only explanation for risk aversion is that the utility function for wealth is concave: A person has lower marginal utility for additional wealth when she is wealthy than when she is poor. This paper provides a theorem showing that expected-utility theory is an utterly implausible explanation for appreciable risk aversion over modest stakes: Within expected-utility theory, for any concave utility function, even very little risk aversion over modest stakes implies an absurd degree of risk aversion over large stakes. Illustrative calibrations are provided. Keywords: Diminishing Marginal Utility, Expected Utility, Risk Aversion JEL Classifications: B49, D11, D81 Acknowledgments: Many people, including David Bowman, Colin Camerer, Eddie Dekel, Larry Epstein, Erik Eyster, Mitch Polinsky, Drazen Prelec, Richard Thaler, and Roberto Weber, as well as Andy Postlewaite and two anonymous referees, have provided useful feedback on this paper. I th...
... People should be risk-averse to any gamble, but the possibility of accepting a gamble is empirically sensitive to stake size. While most people are indeed risk-averse (Holt & Laury, 2002), many people show almost risk neutrality for small stakes if one is an expected utility maximizer (Arrow, 1971; cited in Rabin, 2000b). Markowitz (1952) hypothesized that people would shift from risk-taking for small stakes to risk aversion for large stakes, which was later supported by ample empirical evidence (Fehr-Duda et al., 2010). ...
... Markowitz (1952) hypothesized that people would shift from risk-taking for small stakes to risk aversion for large stakes, which was later supported by ample empirical evidence (Fehr-Duda et al., 2010). Rabin (2000b) stated, "While most economists understand this formal limit result, fewer (Mukherjee, 2019) appreciate that the approximate riskneutrality prediction holds not just for negligible stakes, but for quite sizable and economically important stakes" (p. 1281). ...
... A large body of literature arguing against EUT was indeed related to stake size-pointing out that EUT could not explain plausible risk aversion for modest and small stakes (Rabin, 2000a), paving the way for loss aversion to enter the center stage in decision theory. Rabin (2000bRabin ( , p. 1288 stated: This document is copyrighted by the American Psychological Association or one of its allied publishers. ...
Loss aversion—the tendency to avoid losses—has been one of the fundamental ideas in decision research across psychology and behavioral economics. Building upon the general notion of bad being stronger than good and on prospect theory’s value function, the statement “losses loom larger than gains” became accepted as a fundamental principle of human behavior. However, the possibly important role of the magnitude of stakes in the psychological valuation process has not been formally considered, though it is a salient aspect in both theoretical and empirical terms. To fill that gap, we review various studies before and after prospect theory and find evidence that underscores the role of magnitude in loss aversion. Magnitude-dependent loss aversion is a nuanced proposition that explicitly foregrounds the role of stake size in the psychological valuation of gains versus losses.
... The en-tropic risk measure is a particular example of the general class of methods that model risk aversion by using concave utility functions (convex disutility functions in the cost minimization setting). While the expected (dis)utility framework captures the intuitive notion of diminishing marginal utility, it suffers from the issue that even very little risk aversion over moderate costs leads to unrealistically high degrees of risk aversion over large costs [29,30] (note that this is a limitation of any concave utility function). Additionally, the linear treatment of stochasticity in expected (dis)utility theory is in general too restrictive to be able to account for more general statistics, particularly in the context of capturing extreme events [31,Chapter 6]. ...
... From (10), applying the Schur complement, we know that W − 1 2 x 2 ≤ 1 for any x ∈ E max (W ). Thus, by the Cauchy Schwarz inequality, a sufficient condition for (29) is given by T u F W 1 2 2 ≤ u max , which can be written as ...
In this paper we present a framework for risk-sensitive model predictive control (MPC) of linear systems affected by stochastic multiplicative uncertainty. Our key innovation is to consider a time-consistent, dynamic risk evaluation of the cumulative cost as the objective function to be minimized. This framework is axiomatically justified in terms of time-consistency of risk assessments, is amenable to dynamic optimization, and is unifying in the sense that it captures a full range of risk preferences from risk-neutral (i.e., expectation) to worst case. Within this framework, we propose and analyze an online risk-sensitive MPC algorithm that is provably stabilizing. Furthermore, by exploiting the dual representation of time-consistent, dynamic risk measures, we cast the computation of the MPC control law as a convex optimization problem amenable to real-time implementation. Simulation results are presented and discussed.
... ). Contrary to expected utility theory, which models decisions that perfectly rational agents would make (Rabin (2013) ...
... The concept involves using an S-shaped utility function, which adheres to the diminishing sensitivity property. If we set the weighting function w or utility function u to be the identity function, then we retrieve the classical expected utility mode (Rabin (2013)). ...
Black swan events are statistically rare occurrences that carry extremely high risks. A typical view of defining black swan events is heavily assumed to originate from an unpredictable time-varying environments; however, the community lacks a comprehensive definition of black swan events. To this end, this paper challenges that the standard view is incomplete and claims that high-risk, statistically rare events can also occur in unchanging environments due to human misperception of their value and likelihood, which we call as spatial black swan event. We first carefully categorize black swan events, focusing on spatial black swan events, and mathematically formalize the definition of black swan events. We hope these definitions can pave the way for the development of algorithms to prevent such events by rationally correcting human perception
... 3 We have a broad concept of risk aversion in mind which reflects both the shape of the utility function (i.e., concavity over health) and preferences for less risky utility prospects (Segal and Spivak 1990;Wakker 1994). That is, individuals do not only care about their expected utility but also the utility distribution (Allais 1979;Hagen 1979;Quiggin 1982;Kahneman 1991, 1992;Rabin 2000;Starmer 2000). 4 In line with Deaton (1997), we argue that I(V) should not be interpreted as an objective function policymakers should minimize. ...
Measuring health disparities is key to monitoring health systems, but hitherto disparities in the individual risk people face about their future health has been neglected. This paper integrates individual health risk into income‐related health inequality measurement. We develop a rank dependent health inequality index that considers inequalities in each individual's expected future health and the dispersion of their future health prospects. It is useful when a social planner wants to account for risk averse preferences in the assessment of income‐related inequalities of future health prospects. The empirical application using Australian longitudinal data highlights that neglecting individual risk underestimates income‐related inequalities in future health prospects since the poor not only face worse expected future health, but also faced greater dispersion in their future health prospects compared to the rich.
... Under this approach, the logarithmic case is special among the family of concave utility functions. Although the basic model has been considerably enriched (e.g., Kahnemann & Tverski, 1979) and is still subject to extensive research (e.g., Carroll & Kimball, 1996;Clark & Oswald, 1998;Rabin, 2000), decreasing marginal utility and the concavity of the representation of money is a widely-held principle in economics. A straightforward assumption is that when individuals are asked to represent money in our QPT, they will immediately represent the value in terms of the purchasing capability associated with a certain quantity of money. ...
It has been established that humans use different cognitive models to represent and process numerical quantities. In this study, we investigated whether the representation of monetary values fundamentally differs from the representation of numbers. We also examined the influence of both socio/economic factors and mathematical ability on such representation. A group of adults (N = 272) were tested anonymously with a variant of the number-to-position task (Siegler & Opfer, 2003). They were asked to position on a horizontal line quantities expressed either in numerical format (e.g., 50) in the “Number” conditions or as monetary values (e.g., 50€) in the “Money” conditions. The extremes of the line consisted either of specific values (i.e. “2 or 2€” and “503 or 503€”) in the “Fixed” conditions or of unspecific concepts of quantity (e.g., “little” and ”a lot”) in the “Fuzzy” conditions. A linear model, as opposed to a logarithmic one, provided the best fit of group average data in all experimental conditions except for the “Money-Fuzzy” condition. The percentages of absolute error were significantly larger for Money stimuli than Number stimuli in both Fixed and Fuzzy conditions. This is consistent with the law of diminishing marginal utility, which entails that the value of monetary quantities is described by a concave curve rather than a linear relationship. As expected from previous research, participants who were more used to spending large quantities of money were closer to the linear representation model. Participants with higher mathematical abilities represented numerical values more closely to a linear model, but no such effect was found for monetary quantities.
... From an economic perspective, high levels of risk aversion can lead to suboptimal decisionmaking, particularly in domains such as entrepreneurship and investment. For instance, overly riskaverse behavior may limit entrepreneurial initiatives and result in conservative investment strategies, potentially hindering economic growth, and resilience (Rabin, 2000). a completely risk-seeking person would also accept all of these gambles, regardless of the specific positive EV. ...
Risk aversion—the preference for certainty over potential gains or losses—is reduced when using a foreign language. We investigated 2 mechanisms for this foreign language effect using incentivized gambles with verbal probability expressions: (1) that people perceive prospects of winning as larger when a decision is made in their foreign language; (2) that people experience reduced negative affect toward risk in a foreign language. In Experiment 1, N = 229 proficient Polish–English bilinguals, using ungridded slider, assigned numerical values to 29 verbal probability expressions in both languages. We found small bidirectional differences in 13 of them, leading us to reject the first mechanism. In Experiment 2, N = 281 participants gambled in incentivized neutral expected value lotteries using a sample of the verbal probability expressions from Experiment 1. Participants gambled in either their native or foreign language, where participants could either accept around 50% of gambles (debiased to risk-neutral) or more than 50% (biased to risk-seeking). Surprisingly, we observed no significant risk aversion in either language condition, with participants’ gambling behavior close to 50% in both cases. The finding that participants showed no risk aversion in native language condition meant we could not test whether foreign language reduces risk aversion. However, this result did show that using a foreign language does not promote excessive risk-taking. Our findings suggest that using verbal probability expressions does not bias participants’ responses, and may inherently reduce risk aversion.
... According to this theory, investors base their decisions on the benefits the consumer receives from the various portfolio insurance coverages and the insurance's suitability. As a result, the greater the maximum uncertainty they cover, the higher the expected utility (Rabin, 2013 State-dependent consumer behavior theory: This theory proposes that the purchasing state determines the choice of consumer behavior in purchasing any commodity. Thus, purchasing behavior is influenced by financial, health, and socioeconomic factors. ...
... For a given m i , the expected utility function is given by E[u i (m i , X)]. Following the literature (Rabin 2000, Rockafellar 2020), we assume u i (m i , x) is concave and increasing in x. When d i = 0, the parameter m i disappears and U i [X] simplifies to an expected concave utility over X: ...
In newsvendor settings, producers with risk-averse objectives usually set a low optimal production level, which can lead to economic inefficiency and social welfare loss. To overcome this challenge, we consider a social planner that aims to motivate the production from risk-averse producers. We propose a novel swap contract between the social planner and producer based on the return payoff function developed in Wang et al. (2025). Economically, the return payoff function decouples the producer's production decision from her risk management. We consider a general class of risk-averse optimization problems, in which the producer maximizes an objective of parametric utility functions, subject to a flexible convex risk constraint. The objective covers expected payoff, concave utility, condition value-at-risk, loss penalty, and their linear combinations. We show that the swap contract can increase the producer's optimal production level in an incentive compatible way. Under moderate risk constraints, the risk-neutral production level can be achieved. In addition, the swap contract is budget neutral for the social planner and robust to information asymmetry regarding producer's concrete optimization problem. We further consider a value-at-risk constraint and find that the swap contract is still valid when the constraint is not too stringent. Finally, we extend the swap contract to general newsvendor payoffs with a revised return payoff function, and show that it remains effective in motivating production from risk-averse producers.
... For example, EUT would assert that no sane person would play the lottery since the odds, and hence expected utility, is always against the player. Rabin (2000) has proved mathematically that attempts to explain loss aversion by the utility of wealth are absurd and doomed to fail. His theorem shows that, if EUT holds, then one who rejects a favorable gamble with small stakes is mathematically committed to a foolish level of risk aversion for some larger gamble. ...
... Risk preference refers to the degree to which individuals are willing to engage with risky options. Traditionally, risk preference is categorized into three types: risk aversion, risk-seeking (or riskloving), and risk neutrality [8]. While classical economic theory posits that individuals are generally risk-averse and primarily motivated by profit maximization, real-world scenarios reveal that individuals' risk preferences vary considerably [9]. ...
This paper examines rationality from a bahaviour economic perspective, based on the case of consumers irrationality on Black Friday and investors irrationality in Teslas stock fluctuations, constructing an applicable insight into traditional economic theories. This study mainly focuses on three terms: Mental accounting, risk preference, attention theory and relevant social factors among consumers, investors, and market regulators, which results in market inefficiency and disinformation. Traditional theories suggest absolute rationality in decision-making based on perfect information and unchanged preference while the new behaviour theories reveal that humans are controlled by emotion, herding, fear of risk, and many other reasons that push them away from the rational path. In the key findings, consumers are easily overspending due to loss aversion, unjustified mental accounting, and eye-catching advertisement whereas investors in Tesla react overactive to clutter online but not to the financial condition of the enterprise itself, leading to the swing of stock price. Some rational tools like cooling-off periods and regulatory intervention may be suggested in advice. The final section of the paper indicates the future research direction could be on digital techniques and influences on irrational behaviour, accelerating the insights developed in mitigating the biases and instability.
... Specifically, the theory proposed that all objective rewards are converted to subjective values by comparison to this fluctuating hidden benchmark: at low reference point, a small reward 45 is considered desirable; but at high reference point, the same reward becomes less satisfying or even undesirable. Subsequent studies have shown that nearly all aspects of decision-making show a dependence on the reference point [8][9][10][11][12], a finding compatible with perceptual psychology results [13][14][15]. Consequently, nearly all modern choice theories now incorporate a reference point of some kind, albeit with varying 50 specifications [16][17][18][19][20][21][22]. ...
The reward reference point serves as a hidden benchmark for evaluating options in decision-making. Despite extensive behavioral evidence for reference-dependence, no neural representation of the reference point has been discovered. We analyzed single neuron activity from macaque monkeys performing a decision-making task designed to orthogonalize objective reward values from the reference point. Regression analyses of neuronal activity across six frontal brain regions identified a robust neural representation of the reference point in the ventral bank of anterior cingulate cortex (vbACC). Activity in the dorsal bank of anterior cingulate cortex and the dorsolateral prefrontal cortex, in contrast, encoded the reference-dependent subjective values of the rewards offered or obtained on each trial. The temporal dynamics of these signals and connections between these regions suggest a dedicated neural circuit implementing reference-dependent reward encoding, with the vbACC serving as the reference point signal source modulating activity in other frontal value-encoding areas.
... From an economic perspective, high levels of risk aversion can lead to suboptimal decisionmaking, particularly in domains such as entrepreneurship and investment. For instance, overly riskaverse behavior may limit entrepreneurial initiatives and result in conservative investment strategies, potentially hindering economic growth, and resilience (Rabin, 2000). a completely risk-seeking person would also accept all of these gambles, regardless of the specific positive EV. ...
The Foreign Language effect is claimed to decrease risk aversion. We found no such effect. First, we asked N = 229 Polish native speakers to assign numerical values to verbal probability phrases in Polish and English. After finding very few differences, we conducted an incentivized experiment, N = 281, where Poles had to decide whether they would prefer to receive a granted amount of money or take part in a lottery task where the chance of winning was expressed by the phrases from the pre-test. Regardless of the language, the participants made the same choices.
... These disparities lead some DMs to have markedly heightened expectations for compensation when faced with larger adjustments. According to psychological expectation theory and the risk aversion principle (Kai Ineman & Tversky, 1979;Rabin, 2013), larger adjustments heighten DMs' uncertainty and perceived losses, necessitating higher compensation to encourage acceptance of these adjustments. For example, loan consensus, the expense associated with adjusting a borrower's interest rate from 12 to 13% might vary compared to the adjustment from 6 to 7%. ...
The matching service the lending platform (moderator) provides acts as a facilitative conduit for reaching a loan consensus, facilitating agreements among multiple lenders and borrowers (decision makers). In light of the reality that decision-makers exhibit varying sensitivities to compensation expectations in response to opinion adjustment, the moderator’s demonstration of a preferred compensation mechanism determines the efficiency of the matching service. This article proposes a dynamic cost compensation mechanism driven by moderator preferences for group consensus in lending platforms. Firstly, the utility function describes adjusters’ preferences, defining three unit cost compensation preferences: Power-type I, II and right-partial S-shaped preferences. Subsequently, we construct a generalized dynamic minimum-cost consensus decision model to determine the optimal unit compensation strategies within the opinion interval delineated by the moderator. For the likelihood of equitable concerns arising from fluctuations in unit compensation costs, we enforce the fairness of the compensation strategy by incorporating the Gini coefficient as a constraint within the consensus model. To validate the effectiveness and applicability of the proposed models, we apply the proposed models to online lending utilizing data obtained from an online peer-to-peer lending platform.
... Kahneman and Tversky (1979) infer loss aversion from aversion to gambles like a 50:50 bet to gain $110 or to lose $100. Rabin (2000) proves that the traditional utility framework assumes that a person is risk-neutral over small-stake gambles and should accept this gamble with a positive expected value. However, a typical investor rejects this gamble due to loss aversion because instead of focusing on final expected wealth, he is concerned with gain of $110 or loss of −$100 and as he is much more sensitive to possible loss of $100 than to possible gain of $110, he turns down the gamble. ...
We test whether the effect of macroeconomic surprises on stock returns is impacted by positive or negative investor sentiment, proxied by daily sentiment by Federal Reserve Bank of San Francisco. We employ an event study methodology with separate regressions for six real economic indicators: GDP, industrial production, unemployment, retail sales, durable goods, and continuing jobless claims. We regress the daily stock returns for release dates of macroeconomic indicators on macroeconomic surprises. We test whether a bullish or bearish view about the stock market affects the portfolio choices of investors in response to unexpected macroeconomic news. We find evidence of an asymmetric effect of investor sentiment on the relation between macroeconomic surprises and stock returns.
... Regarding the representation of alternatives' evaluations or performances, essentially it is the issue of information modeling, and there have already many existing means [9][10][11]. One of the simplest and most straightforward ways is using real numbers to express the performances of alternatives, which is founded on the classical expected utility theory [12,13] and has the most solid theoretical basis. But that means is deficient in specially representing uncertain evaluations, where the uncertainty does not only include randomness but also involve vagueness, imprecision, ambiguity, and so on [14,15]. ...
Adversarial decision making is a particular type of decision making problem where the gain a decision maker obtains as a result of his decisions is affected by the actions taken by others. Representation of alternatives' evaluations and methods to find the optimal alternative are two important aspects in the adversarial decision making. The aim of this study is to develop a general framework for solving the adversarial decision making issue under uncertain environment. By combining fuzzy set theory, game theory and D numbers theory (DNT), a DNT based game-theoretic framework for adversarial decision making under fuzzy environment is presented. Within the proposed framework or model, fuzzy set theory is used to model the uncertain evaluations of decision makers to alternatives, the non-exclusiveness among fuzzy evaluations are taken into consideration by using DNT, and the conflict of interests among decision makers is considered in a two-person non-constant sum game theory perspective. An illustrative application is given to demonstrate the effectiveness of the proposed model. This work, on one hand, has developed an effective framework for adversarial decision making under fuzzy environment; One the other hand, it has further improved the basis of DNT as a generalization of Dempster-Shafer theory for uncertainty reasoning.
... Neuroscience re-search suggests that the choice process used by human beings is systematically biased and suboptimal (Fehr and Rangel, 2011). Among the known paradoxes of classical utility making, we can list the Bernoulli St. Petersburg paradox (Bernoulli, 1738), the Allais paradox (Allais, 1953), the independence paradox (Allais, 1953), the Ellsberg paradox (Ellsberg, 1961), the Kahneman-Tversky paradox (Kahneman and Tversky, 1979), the Rabin paradox (Rabin, 2000), the Ariely paradox (Ariely, 2008), the disjunction effect , the conjunction fallacy (Tversky and Kahneman, 1983;Shafir et al., 1990), the isolation effects (McCaffery and Baron, 2006), the combined paradoxes (Yukalov and Sornette, 2009b, 2010b, the planning paradox (Kydland and Prescott, 1977), and dynamic inconsistency (Strotz, 1955;Frederick et al., 2002). A large literature on this topic can be found in the recent reviews (Camerer et al., 2003;Machina, 2008). ...
The influence of additional information on the decision making of agents, who are interacting members of a society, is analyzed within the mathematical framework based on the use of quantum probabilities. The introduction of social interactions, which influence the decisions of individual agents, leads to a generalization of the quantum decision theory developed earlier by the authors for separate individuals. The generalized approach is free of the standard paradoxes of classical decision theory. This approach also explains the error-attenuation effects observed for the paradoxes occurring when decision makers, who are members of a society, consult with each other, increasing in this way the available mutual information. A precise correspondence between quantum decision theory and classical utility theory is formulated via the introduction of an intermediate probabilistic version of utility theory of a novel form, which obeys the requirement that zero-utility prospects should have zero probability weights.
... For instance, in (Howard and Matheson, 1972) the authors leverage the exponential (or entropic) risk. This has historically been a very popular technique for parameterizing risk-attitudes in decision theory but suffers from the usual drawbacks of the EU framework such as the calibration theorem (Rabin, 2000). The latter states that very little risk aversion over moderate costs leads to unrealistically high degrees of risk aversion over large costs, which is undesirable from a modeling perspective. ...
The literature on Inverse Reinforcement Learning (IRL) typically assumes that humans take actions in order to minimize the expected value of a cost function, i.e., that humans are risk neutral. Yet, in practice, humans are often far from being risk neutral. To fill this gap, the objective of this paper is to devise a framework for risk-sensitive IRL in order to explicitly account for a human's risk sensitivity. To this end, we propose a flexible class of models based on coherent risk measures, which allow us to capture an entire spectrum of risk preferences from risk-neutral to worst-case. We propose efficient non-parametric algorithms based on linear programming and semi-parametric algorithms based on maximum likelihood for inferring a human's underlying risk measure and cost function for a rich class of static and dynamic decision-making settings. The resulting approach is demonstrated on a simulated driving game with ten human participants. Our method is able to infer and mimic a wide range of qualitatively different driving styles from highly risk-averse to risk-neutral in a data-efficient manner. Moreover, comparisons of the Risk-Sensitive (RS) IRL approach with a risk-neutral model show that the RS-IRL framework more accurately captures observed participant behavior both qualitatively and quantitatively, especially in scenarios where catastrophic outcomes such as collisions can occur.
... From a theoretical standpoint, our goal function takes the form of a reference-dependent profit function to parallel the concept of reference-dependent utility function that has two parts (e.g. Tversky and Kahneman 1992;Kőszegi and Rabin 2007;Rabin 2000;Dhami 2016). The first part corresponds to the usual pure profit and the second part, the reallocation cost, is reference-dependent with a reference point corresponding to a current level of input and output. ...
The objective of this paper is to propose a theoretical framework where firms are maximizing profit taking into account a reallocation cost. This we do by introducing a reference-dependent profit function. It is shown in this paper that such a reference-dependent profit function is a useful concept to partly explain the existence of inefficiency for firms. Along this line it is shown that one can construct a suitable dynamical process quantifying the catching up of firms to reach the production frontier at each time period.
... Response options included ¥150, ¥200, ¥250, ¥300, and above ¥300. For small-stake choices, risk preferences are governed by loss aversion, as argued by Rabin (2000). Assuming linearity in utility and probability weighting (e.g., Kahneman and Tversky 1979), a respondent who chose the option ¥200 exhibits a degree of loss aversion of 2. For the subsequent analysis, we convert these options into five different levels of loss aversion, namely 1, 2, 3, 4, and 5. ...
This paper utilizes data from the 2017 China Household Finance Survey (CHFS) to examine the impact of loss aversion on individuals' willingness to relocate due to environmental concerns. We find that individuals who are more loss averse are less likely to consider moving, resulting in what is called the status-quo bias. In addition, we find that individuals with stronger family ties as measured by the number of siblings and higher household fixed assets are more susceptible to these effects, implying that they are more attached to their current place of residence and less likely to relocate.
... Kayıptan kaçınma, deneysel bağlamda gözlemlenen risk alma davranışındaki birçok anormalliği açıklamak için ikna edici bir yaklaşım sunar. Özellikle, birçok bireyin, beklenen fayda teorisi çerçevesinde açıklanamayacak olan hem kazanç hem de kayıpları içeren görünüşte avantajlı piyangoları neden reddettiğini açıklar (Rabin, 2000). Ayrıca, kayıptan kaçınma kesinlik durumunda verilen kararlara da genişletilebilir. ...
ÇEVRESEL SÜRDÜRÜLEBİLİRLİK VE EKONOMİK
VERİMLİLİĞİN ME-DEA YÖNTEMİ AÇISINDAN
DEĞERLENDİRİLMESİ: AB ÖRNEĞİ
... Assuming, as a rational theory must(Rabin, 2000), that utility increases roughly linearly with money for small stakes 4 Note that in this hypothetical example, the baker still values money to some extent -otherwise, he wouldn't be in the baking business, or indeed any business at all. That being the case, the pauper maintains some bargaining power (via whatever money he has), which enables an exchange. ...
It is widely agreed upon that morality guides people with conflicting interests towards agreements of mutual benefit. We therefore might expect numerous proposals for organizing human moral cognition around the logic of bargaining, negotiation, and agreement. Yet, while “contractualist” ideas play an important role in moral philosophy, they are starkly underrepresented in the field of moral psychology. From a contractualist perspective, ideal moral judgments are those that would be agreed to by rational bargaining agents—an idea with wide-spread support in philosophy, psychology, economics, biology, and cultural evolution. As a practical matter, however, investing time and effort in negotiating every interpersonal interaction is unfeasible. Instead, we propose, people use abstractions and heuristics to efficiently identify mutually beneficial arrangements. We argue that many well-studied elements of our moral minds, such as reasoning about others’ utilities (“consequentialist” reasoning) or evaluating intrinsic ethical properties of certain actions (“deontological” reasoning), can be naturally understood as resource-rational approximations of a contractualist ideal. Moreover, this view explains the flexibility of our moral minds—how our moral rules and standards get created, updated and overridden and how we deal with novel cases we have never seen before. Thus, the apparently fragmentary nature of our moral psychology—commonly described in terms of systems in conflict—can be largely unified around the principle of finding mutually beneficial agreements under resource constraint. Our resulting “triple theory” of moral cognition naturally integrates contractualist, consequentialist and deontological concerns.
... People are asked in ascending order how much they would pay for that lottery (or, equivalently, how much income they would give up) without asking them the exact percentage. Also, the amount at stake is relevant, given that is proportional to their income, by making the lottery more credible and of a substantial amount compared to their current resources (Rabin, 2000). Table 2 illustrates that our measure of risk tolerance has more uneven values, with a peak at 0.5, which corresponds to the risk-neutral individual who would pay the exact amount of the lottery value. ...
Plain English Summary
Is impatience holding back digital innovation in Italian firms? This study investigates how entrepreneurs’ impatience and risk attitudes affect their investment in digital technologies. Using data from a survey of Italian firms and an innovative approach that leverages earthquakes as a natural experiment, we discovered that impatience significantly reduces the likelihood of investing in digital technologies, even when accounting for risk preferences. This suggests that entrepreneurs’ tendency towards impatience can be a major barrier to adopting essential digital innovations. The findings underscore the importance of developing policies that promote long-term investment strategies and help entrepreneurs build patience. Such policies could facilitate greater adoption of digital technologies and boost business competitiveness.
... This is not the first study conducted in this framework. For experimental studies casting doubt on the validity of expected utility paradigm of von-Neumann and Morgenstern (1953), see Markowitz (1952b), Kahneman and Tversky (1979) and Rabin (2000). Nevertheless, before burying expected utility paradigm recall that many theoretical economic results are derived within this paradigm, results that cannot be derived with prospect theory model, e.g., Markowitz (1952a) Mean-Variance analysis, the equilibrium prices of risky assets, like the Capital Asset Pricing Model developed by Sharpe (1964), Lintner (1965) and Mossin (1966), and the optimal capital structure and cost of capital analysis of Miller (1958, 1969). ...
By the Almost First-degree Stochastic Dominance (AFSD) rule, corresponding only to economically relevant preferences, for an infinite horizon the theoretical claim of both Markowitz and Samuelson is not intact. However, for the practically more relevant case of the long but finite horizon, with stocks-bonds portfolios, Markowitz empirically is right as we find that the MGM portfolio coincides with the optimal myopic portfolio for all risk aversion parameters . For the MGM portfolio dominates by AFSD rule all optimal myopic portfolios, as long as the investment horizon is 12–15 years or longer.
... For instance, when a power utility function is assumed, that is, u(x) = x k , the resulting nonlinear least squares estimate is k = 0.995. These results are in line with the findings of Wakker and Deneffe (1996) (in the case of small stakes), Bruhin, Fehr-Duda, and Epper (2010), Epper, Fehr-Duda, and Bruhin (2011), and Abdellaoui et al. (2011, and are consistent with the critique put forward by Rabin (2000). These results also support Assumption 4. Given these findings, and since the main focus of the analysis is probabilistic risk attitude, I relegate the full analysis of utility functions and their shape to Supplemental Appendix D. ...
I show that stochastic contracts generate powerful incentives when agents suffer from probability distortion. When implementing these contracts, the principal can target probability distortions in order to inflate the agent's perceived benefits of exerting high levels of effort. This novel source of motivation is absent in contracts traditionally regarded as optimal. A theoretical framework and an experiment demonstrate that stochastic contracts implemented with small probabilities, which expose the agent to a high degree of risk, generate higher performance than cost‐equivalent contracts with lower or no risk exposure. I find that probability distortions that result from likelihood insensitivity—cognitive limitations that prevent the accurate evaluation of probabilities—account for this finding. The results highlight the limits of contracts traditionally regarded as optimal.
... It uses a multi-attribute utility function, which is concave in these attributes rather than in income. It is thus not subject to the potential criticism of small stakes risk aversion (Rabin 2000, Watt 2002, Harrison et al. 2017) that arise with concavity in income. Moreover, as in only a handful of other studies, our data come from choice experiments in hypothetical contexts that are familiar to agents, rather than from paired lottery choices in the laboratory. ...
Outdoor recreation is among the most popular leisure activities in the world. Taking place in an uncertain environment, agents incur travel costs to discover the payoff only after arriving at the site. Building on recent developments in behavioral economics suggesting a variety of patterns of behavior inconsistent with expected utility, we specify recreationists' preferences as rank-dependent. Using data from a 2022 stated preference survey in the East Coast summer flounder recreational fishery, our results confirm that previous empirical findings can be applied to the domain of recreation. As in the case of financial, insurance, and medical decisions, our subjects exhibit a pattern of probability weights consistent with an inverse S-shaped probability weighting function that overweights small-tail probabilities and underweights intermediate and large probabilities. Our results have important implications for the management of outdoor recreation. Lastly, we illustrate how our model could be estimated using revealed rather than stated preference data.
Narrow bracketers who are myopic in specific decisions would fail to consider preexisting risks in investment and neglect hedging opportunities. Growing evidence has demonstrated the relevance of narrow bracketing. We take a step further in empirical investigation and study individual heterogeneity in narrow bracketing. Specifically, we use a lab experiment in investment and hedging that elicits subjects’ preferences on rich occasions to uncover the individual degree of narrow bracketing without imposing distributional assumptions. Combining prospect theory and narrow bracketing can explain our findings: Subjects who invest more also insure more, and subjects insure significantly less in the loss domain than in the gain domain. More importantly, we show that the distribution of the individual degree of narrow bracketing is skewed at two extremes, yet with a substantial share of people in the middle who partially suffer from narrow bracketing. Neglecting this aspect, we would overestimate the severity of narrow bracketing and misinterpret its relation with individual characteristics.
This study examines how task assignment mechanisms affect the participation of workers on decentralized blockchains. In developing the theory, I highlight that blockchain represents a distinct organizational form for coordinating operations under a highly decentralized structure, in which the essential tasks of system infrastructure maintenance are assigned to third‐party crowd workers through the unique governance mechanism of consensus protocol. I specifically focus on two widely adopted consensus protocols in the context of cryptocurrency, namely, proof‐of‐work (PoW), which assigns tasks that sustain the blockchain system operation based on workers' investments in computing power, and proof‐of‐stake (PoS), which assigns these tasks based on workers' investments in the native cryptocurrency as stakes. I argue that compared with PoW, PoS increases worker participation and task decentralization because the investment requirement of task participation in the form of blockchain native assets reduces workers' transaction costs in task contracting and their tendencies for hyper‐competition. My empirical analysis leverages a natural experiment on Ethereum, namely, the “Merge” event on September 15, 2022, in which the blockchain changed the assignment rules by switching the consensus protocol from PoW to PoS. The results under a difference‐in‐differences research design confirm my arguments.
Cognitive economics studies imperfect information and decision-making mistakes. A central scientific challenge is that these can’t be identified in standard choice data. Overcoming this challenge calls for data engineering, in which new data forms are introduced to separately identify preferences, beliefs, and other model constructs. I present applications to traditional areas of economic research, such as wealth accumulation, earnings, and consumer spending. I also present less traditional applications to assessment of decision-making skills, and to human–AI interactions. Methods apply both to individual and to collective decisions. I make the case for broader application of data engineering beyond cognitive economics. It allows symbiotic advances in modeling and measurement. It cuts across existing boundaries between disciplines and styles of research. (JEL C45, C80, D15, D80, D91, G50, J24)
We provide experimental evidence of a positive memory bias that affects individuals’ beliefs, decisions to reinvest, and overconfidence in the stock market. Individuals overremember positive investment outcomes of chosen assets and underremember negative ones. Based on their memories, subjects form overly optimistic beliefs about their investment, reinvest too much, and become overconfident about their investment ability relative to others. We further provide evidence on motivation driving the memory bias. This positive memory bias offers a cognitive microfoundation for why gains weight more than losses when people learn from experiences. This helps reconcile various stylized facts in investor beliefs and behavior. (JEL D01, G4)
Our descriptive understanding of observed insurance behavior has been enhanced by considering alternative modeling approaches, and promises to do the same to our normative evaluation of that behavior. Those alternatives come from the field of behavioral economics, which offers explicit, alternative characterizations of the way in which decisions have been made. The value of these alternatives is clear in a wide range of topics in empirical insurance, to the point where there is now no reason to debate why we need to consider them. Indeed, recognition that behavioral insurance has come to stay in our scholarship allows us to signal the end of the need to even make the case for behavioral insurance. However, that recognition does not mean that every claim from behavioral insurance is to be accepted at face value, and many are dubious or loosely applied. Much remains to be done more carefully, and much simply remains to be done.
We develop and apply a novel semi-parametric estimation method based on L-moments. Unlike conventional moments, L-moments are linear in the data and therefore robust to outliers. The estimation method provides a series expansion that quickly converges to the underlying return distribution and can be used when conventional moments do not exist. An extensive empirical analysis of portfolio choice under non-expected utility demonstrates the effectiveness of our approach. Empirical results show that our method copes well with estimation risk, yields stable portfolio returns, and reaps the information content of moment returns beyond order four.
Two common incentives for participating in exercise programs are cash rewards for meeting goals and the loss of deposited money when goals are missed. Direct cash rewards lead to higher enrollment, but the risk of losing money is a stronger motivator for sticking with a program. We conducted an experiment using loss protection to leverage the power of both approaches. Participants were offered two exercise classes a week for 12 weeks. Anyone who attended the first weekly class received a chance to play a lottery that was very likely to pay a cash reward, but they also faced a low risk of not winning any money. Participants in the loss-protection group could insure against the loss by also attending the second class of the week. Participants in the control group could earn the equivalent money by likewise attending the second class, but the incentive was a straight reward for class participation (a flat payment), not as loss protection. For any weekly pattern of attendance, expected earnings were the same in both groups. We randomly assigned 153 participants to either the loss-protection or the control group. The loss-protection framing resulted in greater exercise class attendance, suggesting that the approach could enhance the outcomes of reward-based programs without increasing program costs.
This research is motivated by the problems occurring in Karawang Regency, namely the increasing unemployment rate due to the high Regency/City Minimum Wage (UMK), the shift in investment from labor-intensive to capital-intensive, the Covid-19 pandemic, inadequate labor absorption, and competition between indigenous communities. Karawang Regency and immigrants. Dynamic Governance of the Karawang Regency Government is something that can be seen to determine the ability of the Karawang Regency Government to deal with the dynamics that occur in the unemployment problem. The aim of this research is to determine the dynamic governance of the Karawang Regency Government in reducing unemployment in 2019-2023. In this research, the author used descriptive qualitative methods. Data collection was carried out by interviews, observation and documentation. Determination of informants was determined using purposive techniques. The research results show that the Karawang Regency Government's dynamic governance in reducing unemployment can be seen from three aspects of dynamic governance. These three aspects are culture with elements of markets, namely a fair market, long term, namely long-term plans, relevance, namely policies that are in accordance with wishes, growth, namely growth, and stability, namely stability. The second aspect of capabilities with a thinking ahead element is thinking ahead about problems that occur, thinking again, namely carrying out a review or rethinking existing policies and programs, and thinking across, namely thinking across boundaries by adopting various methods from existing references. Lastly, the change aspect is the result of the culture aspect and the capability aspect. In this case, the Karawang Regency Government has implemented dynamic governance by reducing the unemployment rate with various programs and policies in Karawang Regency, which in 2019-2022 experienced fluctuations. Based on the research results, it can be concluded that the Karawang Regency Government's handling of reducing unemployment has produced positive results. So that adaptive policies can be created. The researcher's suggestion is that the Karawang Regency Government can collaborate with the surrounding Regional Government to discuss the problem of unemployment so that relationships can be established and create programs that can be worked on together or new policies. The government must also know its duties as the executor of existing policies. Don't forget to maintain consistency in carrying out tasks, principals and functions.
I conduct a version of Rabin's (2000) calibration exercise in the subjective expected utility realm. I show that the rejection of some risky bet by a risk-averse agent only implies the rejection of more extreme and less desirable bets and nothing more.
Purpose
This study aims to identify individuals' biases while making investment decisions and explore how these biases can be incorporated into a robo-advisory platform to help mitigate these biases. This paper identifies eight investment-related behavioral biases: mental accounting, gambler’s fallacy, hindsight, regret aversion, disposition, trend-chasing, loss aversion and herding.
Design/methodology/approach
This study uses primary data from 263 respondents across various age groups, of which approximately 50 were wealth management professionals in the UAE. A random sampling method from probability sampling is employed to gather the primary data. The identified biases serve as dependent variables; the age and income of individuals serve as the independent variables.
Findings
Age and income are significantly related to mental accounting, herding, gambler fallacy and loss aversion. Existing studies on behavioral finance demonstrate that individuals who make investment decisions are susceptible to cognitive fallacies, leading to nonrational investment decisions.
Practical implications
By studying these biases affecting individuals of varying ages and income levels, wealth management professionals can tailor their financial robo-advisory services to address these biases and help clients build wealth with consistent investment.
Originality/value
This study uses survey-based sampling in the context of the UAE; hence, the data and analysis represent originality.
Risk economics examines decision-making under uncertainty, rooted in expected utility theory (EU). EU theory postulates that individuals maximize expected utility, not financial outcomes. This inquiry underscores the interplay between economic behavior, uncertainty, and utility, advocating for nuanced theoretical approaches to risk economics. The economic system significantly influences risk tolerance, especially during disasters. Higher GDP often mitigates disaster mortalities, yet GDP fails as a metric for assessing disaster damages, emphasizing capital replacement's criticality. Capital replacement, driven by depreciation, taxation, and investment, is destabilized by natural disasters and climate risks, impacting economic resilience. Resilience encompasses recovery speed, institutional capacity, and market adaptability to shocks. This chapter explores the intricate relationship between risk and utility in economic decision-making. It critiques expected utility theory, emphasizing evolving attitudes toward risk, concavity of utility functions, and probability constraints. This chapter examines Keynes, Knight, and Kahneman's theories; it highlights how uncertainty, marginal utility, and externalities influence economic choices. Utility loss, risk, and economic return are pivotal in disaster and climate risk management. Disaster-induced utility loss impacts asset valuation, GDP, and financial stability. Integrating climate action into financial strategies enhances utility and mitigates volatility. Developing economies face heightened challenges in balancing investment, climate risks, and returns, necessitating innovative sustainable growth and resilience approaches.
In a model inspired by neuroscience, we study choice between lotteries as a process of encoding and decoding noisy perceptual signals. The implications of this process for behavior depend on the decision-maker’s understanding of risk. When the aggregation of perceptual signals is coarse, encoding and decoding generate behavioral risk attitudes even for vanishing perceptual noise. We show that the optimal encoding of lottery rewards is S-shaped and that low-probability events are optimally oversampled. Taken together, the model can explain adaptive risk attitudes and probability weighting, as in prospect theory. Furthermore, it predicts that risk attitudes are influenced by the anticipation of risk, time pressure, experience, salience, and availability heuristics.
We measure individual-level loss aversion using three incentivized, representative surveys of the U.S. population (combined N=3,000). We find that around 50% of the U.S. population is loss tolerant—they are willing to accept negative-expected-value gambles that contain a loss. This is counter to expert predictions and earlier findings—which mostly come from laboratory/student samples—that 70–90% of participants are loss averse. Consistent with the different findings in our study versus the prior literature, loss aversion is more prevalent in people with high cognitive ability. Further, our measure of gain–loss attitudes exhibits similar temporal stability and better predictive power outside our survey than measures of risk aversion. Loss-tolerant individuals are more likely to report recent gambling, investing a higher percentage of their assets in stocks, and experiencing financial shocks. These results support the general hypothesis that individuals value gains and losses differently, and that gain–loss attitudes are an important economic preference. However, the tendency in a large proportion of the population to emphasize gains over losses is an overlooked behavioural phenomenon.
Experiments suggest that people fail to take into account interdependencies between their choices—they do not broadly bracket. Researchers often instead assume people narrowly bracket, but existing designs do not test it. We design a novel experiment and revealed preference tests for how someone brackets their choices. In portfolio allocation under risk, social allocation, and induced-value shopping experiments, 40–43 percent of subjects are consistent with narrow bracketing, and 0–16 percent with broad bracketing. Adjusting for each model’s predictive precision, 74 percent of subjects are best described by narrow bracketing, 13 percent by broad bracketing, and 6 percent by intermediate cases. (JEL D12, D81, D91)
Any utility function that is unbounded either from below or from above implies paradoxical behavior. However, these paradoxes may be regarded as irrelevant if they involve wealth levels that are realistically meaningless. Employing real-world constraints on wealth reveals that CRRA utility with relative risk aversion outside of the range 0.75–1.15 yields paradoxical choices that very few individuals, if any, would ever make. Thus, relative risk aversion must be close to 1, the value corresponding to log preferences. These results shed new light on the longstanding debate about the geometric-mean criterion and the argument of stocks for the long-run.
The equity premium puzzle refers to the empirical fact that stocks have outperformed bonds over the last century by a surprisingly
large margin. We offer a new explanation based on two behavioral concepts. First, investors are assumed to be “loss averse,”
meaning that they are distinctly more sensitive to losses than to gains. Second, even long-term investors are assumed to evaluate
their portfolios frequently. We dub this combination “myopic loss aversion.” Using simulations, we find that the size of the
equity premium is consistent with the previously estimated parameters of prospect theory if investors evaluate their portfolios
annually.
Ffifteen years ago, the theory of choice under uncertainty could be considered one of the “success stories” of economic analysis: it rested on solid axiomatic foundations, it had seen important breakthroughs in the analytics of risk, risk aversion and their applications to economic issues, and it stood ready to provide the theoretical underpinnings for the newly emerging “information revolution” in economics.1 Today choice under uncertainty is a field in flux: the standard theory is being challenged on several grounds from both within and outside economics. The nature of these challenges, and of our profession’s responses to them, is the topic of this paper.
Recent experimental choice studies compare expected utility with competing theories of decision-making under risk. Formal tests used to judge the theories usually count the number of consistent responses, ignoring systematic variation in inconsistent responses. A maximum-likelihood estimation method is developed that extracts more information from the data and enables one to judge the predictive utility--fit and parsimony--of utility theories. Analyses of twenty-three data sets suggest a menu of theories that sacrifice the least parsimony for the biggest improvement in fit. The menu is mixed fanning, prospect theory, expected utility, and expected value. Copyright 1994 by The Econometric Society.
A wine-loving economist we know purchased some nice Bordeaux wines years ago at low prices. The wines have greatly appreciated in value, so that a bottle that cost only 200 at auction. This economist now drinks some of this wine occasionally, but would neither be willing to sell the wine at the auction price nor buy an additional bottle at that price. Thaler (1980) called this pattern—the fact that people often demand much more to give up an object than they would be willing to pay to acquire it—the endowment effect. The example also illustrates what Samuelson and Zeckhauser (1988) call a status quo bias, a preference for the current state that biases the economist against both buying and selling his wine. These anomalies are a manifestation of an asymmetry of value that Kahneman and Tversky (1984) call loss aversion—the disutility of giving up an object is greater that the utility associated with acquiring it. This column documents the evidence supporting endowment effects and status quo biases, and discusses their relation to loss aversion.
Decision theory and the theory of rational choice have recently been the subjects of considerable research by philosophers and economists. However, no adequate anthology exists which can be used to introduce students to the field. This volume is designed to meet that need. The essays included are organized into five parts covering the foundations of decision theory, the conceptualization of probability and utility, pholosophical difficulties with the rules of rationality and with the assessment of probability, and causal decision theory. The editors provide an extensive introduction to the field and introductions to each part.
Decision makers have a strong tendency to consider problems as unique. They isolate the current choice from future opportunities and neglect the statistics of the past in evaluating current plans. Overly cautious attitudes to risk result from a failure to appreciate the effects of statistical aggregation in mitigating relative risk. Overly optimistic forecasts result from the adoption of an inside view of the problem, which anchors predictions on plans and scenarios. The conflicting biases are documented in psychological research. Possible implications for decision making in organizations are examined.
The paper gives necessary and sufficient conditions for an expected-utility-maximizing decision maker to prefer any compound Σni = 1X̃i of n independent, identically distributed random variables over any other such compound Σni = 1Ỹi with EỸi < EX̃i, provided that n is sufficiently large. A sufficient condition is that absolute risk aversion go to zero as the decision maker′s wealth becomes unboundedly positive or negative. The analysis is applied to give necessary and sufficient conditions for the desirability of "max-expected-log" policies in multiperiod choice problems with a distant time horizon. Journal of Economic Literature Classification Numbers: D81, G11, G21, G22.
This paper defines a new concept of attitude towards risk. For an actuarially fair random variable is the risk premium the decisionmaker is willing to pay to avoid . In expected utility, and as it turns out, in the case of smooth Freéchet differentiability of the representation functional, π′(0) = 0. There are models (e.g., rank dependent probabilities) in which . We call the latter attitude as being of order 1, and we call the first one attitude of order 2. These concepts are then applied to analyze the problem of full insurance.
A representative-agent model with time-varying moments of consumption growth is used to analyze implications about means and volatilities of asset returns as well as the predictability of asset returns for various investment horizons. A comparative-statics analysis using nonexpectedutility preferences indicates that, although risk aversion is important in determining the means of both equity returns and interest rates, implications about the volatility and the predictability of equity returns are affected primarily by intertemporal substitution. Lower elasticities of intertemporal substitution are associated with greater variance in the temporary component of equity prices.
Much experimental evidence indicates that choice depends on the status quo or reference level: changes of reference point often lead to reversals of preference. The authors present a reference-dependent theory of consumer choice, which explains such effects by a deformation of indifference curves about the reference point. The central assumption of the theory is that losses and disadvantages have greater impact on preferences than gains and advantages. Implications of loss aversion for economic behavior are considered. Copyright 1991, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.
A decision maker's attitude towards risk is said to be of order (i), (i) = 1, 2, if for every given risk (e) with expected value zero, the risk premium the decision maker is willing to pay to avoid the risk (te) goes with (t) to zero at the same order as t[superscript i]. This article presents an experiment testing the order of decision makers' attitudes toward risk. Its major result is that both attitudes exist, each in significant proportions. Moreover, two classes of first-order behavior are defined. The rank-dependent model (Quiggin, 1982) belongs to one, the disappointment aversion model (Gul, 1991) to the other. We show that only the first of these two classes appears among our subjects.
Copyright 1994 by Kluwer Academic Publishers
When making many choices, a person can broadly bracket them by assessing the consequences of all of them taken together. or narrowly bracket them by making each choice in isolation. We integrate research conducted in a wide range of decision contexts which shows that choice bracketing is an important determinant of behavior. Because broad bracketing allows people to take into account all the consequences of their actions, it generally leads to choices that yield higher utility. The evidence that we review, however, shows that people often fail to bracket broadly when it would be feasible for them to do so. In addition to documenting the diverse effects of bracketing, we also discuss factors that determine whether people bracket narrowly or broadly. We conclude with a discussion of normative aspects of bracketing and argue that there are some situations in which narrower bracketing results in superior decisionmaking.
Copyright 1999 by Kluwer Academic Publishers
Only one-fourth of U.S. families own stock. This paper examines whether the consumption of stockholders differs from the consumption of nonstockholders and, if so, whether these differences help explain the empirical failures of the consumption-based CAPM. Household panel data are used to construct time series on the consumption of each group. The results indicate that the consumption of stockholders is more volatile and more highly correlated with the excess return on the stock market. These differences help explain the size of the equity premium, although they do not fully resolve the equity premium puzzle.
We propose a model of consumption and saving based on Kahneman and Tversky's Prospect Theory that implies a fundamental asymmetry in consumption behavior inconsistent with other models of consumption. When there is sufficient income uncertainty, a person resists lowering consumption in response to bad news about future income. This resistance is greater than the resistance to increasing consumption in response to good news. We present empirical evidence from five countries that confirms this behavior.
This paper integrates Yaari's dual theory of choice under uncertainty into a multiperiod context and examines its implications for the equity premium puzzle. An important property of these preferences is that of ‘first-order risk aversion’ which implies, in our model, that the risk premium for a small gamble is proportional to the standard deviation rather than the variance. Since the standard deviation of the growth rate in aggregate consumption is considerably larger than its variance, the model can generate both a small risk-free rate and a moderate equity premium.
Time and value are related concepts that influence human behaviour. Although classical topics in human thinking throughout the ages, few environmental economic non-market valuation studies have attempted to link the two concepts. Economists have estimated non-market environmental values in monetary terms for over 30 years. This history of valuation provides an opportunity to compare value estimates and how valuation techniques have changed over time. This research aims to compare value estimates of benefits of a protected natural area. In 1978, Nadgee Nature Reserve on the far south coast of New South Wales was the focus of the first application of the contingent valuation method in Australia. This research aims to replicate that study using both the original 1978 contingent valuation method questionnaire and sampling technique, as well as state of the art non-market valuation tools. This replication will provide insights into the extent and direction of changes in environmental values over time. It will also highlight the impact on value estimates of methodological evolution. These insights will help make allocating resources more efficient.
Analysis of decision making under risk has been dominated by expected utility theory, which generally accounts for people's actions. Presents a critique of expected utility theory as a descriptive model of decision making under risk, and argues that common forms of utility theory are not adequate, and proposes an alternative theory of choice under risk called prospect theory. In expected utility theory, utilities of outcomes are weighted by their probabilities. Considers results of responses to various hypothetical decision situations under risk and shows results that violate the tenets of expected utility theory. People overweight outcomes considered certain, relative to outcomes that are merely probable, a situation called the "certainty effect." This effect contributes to risk aversion in choices involving sure gains, and to risk seeking in choices involving sure losses. In choices where gains are replaced by losses, the pattern is called the "reflection effect." People discard components shared by all prospects under consideration, a tendency called the "isolation effect." Also shows that in choice situations, preferences may be altered by different representations of probabilities. Develops an alternative theory of individual decision making under risk, called prospect theory, developed for simple prospects with monetary outcomes and stated probabilities, in which value is given to gains and losses (i.e., changes in wealth or welfare) rather than to final assets, and probabilities are replaced by decision weights. The theory has two phases. The editing phase organizes and reformulates the options to simplify later evaluation and choice. The edited prospects are evaluated and the highest value prospect chosen. Discusses and models this theory, and offers directions for extending prospect theory are offered. (TNM)
MyopicLossAversion andtheEquity PremiumPuzzle,’’Quar-terly
- S Benartzi
- R Thaler
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