Probability and Risk: Foundations and Economic Implications of Probability-Dependent Risk Preferences
AbstractA 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 InfoArticle provided by Annual Reviews in its journal Annual Review of Economics.
Volume (Year): 4 (2012)
Issue (Month): 1 (07)
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Find related papers by JEL classification:
- D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- C81 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - Methodology for Collecting, Estimating, and Organizing Microeconomic Data
- C90 - Mathematical and Quantitative Methods - - Design of Experiments - - - General
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