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Probability and Risk: Foundations and Economic Implications of Probability-Dependent Risk Preferences

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Author Info

  • Helga Fehr-Duda

    ()
    ( Institute for Environmental Decisions, ETH Zürich, 8092 Zürich, Switzerland)

  • Thomas Epper

    ()
    ( Institute for Environmental Decisions, ETH Zürich, 8092 Zürich, Switzerland
    Department of Economics, University of Zürich, 8006 Zürich, Switzerland)

Abstract

A large body of evidence has documented that risk preferences depend nonlinearly on outcome probabilities. We discuss the foundations and economic consequences of probability-dependent risk preferences and offer a practitioner's guide to understanding and modeling probability dependence. We argue that probability dependence provides a unifying framework for explaining many real-world phenomena, such as the equity premium puzzle, the long-shot bias in betting markets, and households' underdiversification and their willingness to buy small-scale insurance at exorbitant prices. Recent findings indicate that probability dependence is not just a feature of laboratory data, but is indeed manifest in financial, insurance, and betting markets. The neglect of probability dependence may prevent researchers from understanding and predicting important phenomena.

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Bibliographic Info

Article provided by Annual Reviews in its journal Annual Review of Economics.

Volume (Year): 4 (2012)
Issue (Month): 1 (07)
Pages: 567-593

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Handle: RePEc:anr:reveco:v:4:y:2012:p:567-593

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Related research

Keywords: risk preferences; rank-dependent utility; cumulative prospect theory; disappointment aversion; probability weighting;

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References

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Citations

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Cited by:
  1. Andersson, Ola & Holm, Håkan J. & Tyran, Jean-Robert & Wengström, Erik, 2013. "Deciding for Others Reduces Loss Aversion," Working Papers 2013:30, Lund University, Department of Economics.
  2. Andersson, Ola & Tyran, Jean-Robert & Wengström, Erik & Holm, Håkan J., 2013. "Risk Aversion Relates to Cognitive Ability: Fact or Fiction?," Working Paper Series 964, Research Institute of Industrial Economics.
  3. Levon Barseghyan & Francesca Molinari & Ted O'Donoghue & Joshua C. Teitelbaum, 2013. "Distinguishing Probability Weighting from Risk Misperceptions in Field Data," American Economic Review, American Economic Association, vol. 103(3), pages 580-85, May.
  4. Riedl A.M. & Wölbert E.M., 2013. "Measuring Time and Risk Preferences: Reliability, Stability, Domain Specificity," Research Memorandum 041, Maastricht University, Graduate School of Business and Economics (GSBE).
  5. Eyal Baharad & Doron Kliger, 2013. "Market failure in light of non-expected utility," Theory and Decision, Springer, vol. 75(4), pages 599-619, October.
  6. Thomas Epper & Helga Fehr-Duda, 2012. "The missing link: Unifying risk taking and time discounting," ECON - Working Papers 096, Department of Economics - University of Zurich.
  7. Ryan O. Murphy & Robert H.W. ten Brincke, . "Hierarchical maximum likelihood parameter estimation for cumulative prospect theory: Improving the reliability of individual risk parameter estimates," Working Papers ETH-RC-14-005, ETH Zurich, Chair of Systems Design.
  8. Nicholas Barberis, 2013. "The Psychology of Tail Events: Progress and Challenges," American Economic Review, American Economic Association, vol. 103(3), pages 611-16, May.
  9. Antoni Bosch-Domènech & Joaquim Silvestre, 2013. "Measuring risk aversion with lists: a new bias," Theory and Decision, Springer, vol. 75(4), pages 465-496, October.
  10. Andersson, Ola & Holm, Håkan J. & Tyran, Jean-Robert & Wengström, Erik, 2013. "Risking Other People’s Money: Experimental Evidence on Bonus Schemes, Competition, and Altruism," Working Paper Series 989, Research Institute of Industrial Economics.

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