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The Uncertainty Effect: When a Risky Prospect Is Valued Less Than Its Worst Possible Outcome

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  • Uri Gneezy
  • John A List
  • George Wu

Abstract

Expected utility theory, prospect theory, and most other models of risky choice are based on the fundamental premise that individuals choose among risky prospects by balancing the value of the possible consequences. These models, therefore, require that the value of a risky prospect lie between the value of that prospect's highest and lowest outcome. Although this requirement seems essential for any theory of risky decision-making, we document a violation of this condition in which individuals value a risky prospect less than its worst possible realization. This demonstration, which we term the uncertainty effect, draws from more than 1000 experimental participants, and includes hypothetical and real pricing and choice tasks, as well as field experiments in real markets with financial incentives. Our results suggest that there are choice situations in which decision-makers discount lotteries for uncertainty in a manner that cannot be accommodated by standard models of risky choice. Copyright by the President and Fellows of Harvard College and the Massachusetts Institute of Technology.

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Bibliographic Info

Article provided by MIT Press in its journal The Quarterly Journal of Economics.

Volume (Year): 121 (2006)
Issue (Month): 4 (November)
Pages: 1283-1309

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Handle: RePEc:tpr:qjecon:v:121:y:2006:i:4:p:1283-1309

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  1. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  2. Fox, Craig R & Tversky, Amos, 1995. "Ambiguity Aversion and Comparative Ignorance," The Quarterly Journal of Economics, MIT Press, vol. 110(3), pages 585-603, August.
  3. Machina, Mark J, 1987. "Choice under Uncertainty: Problems Solved and Unsolved," Journal of Economic Perspectives, American Economic Association, vol. 1(1), pages 121-54, Summer.
  4. Kahneman, Daniel & Ritov, Ilana & Schkade, David A, 1999. "Economic Preferences or Attitude Expressions?: An Analysis of Dollar Responses to Public Issues," Journal of Risk and Uncertainty, Springer, vol. 19(1-3), pages 203-35, December.
  5. Gneezy, Uri & Potters, Jan, 1997. "An Experiment on Risk Taking and Evaluation Periods," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 631-45, May.
  6. Benartzi, Shlomo & Thaler, Richard H, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 73-92, February.
  7. John A. List, 2001. "Do Explicit Warnings Eliminate the Hypothetical Bias in Elicitation Procedures? Evidence from Field Auctions for Sportscards," American Economic Review, American Economic Association, vol. 91(5), pages 1498-1507, December.
  8. Conlisk, John, 1993. " The Utility of Gambling," Journal of Risk and Uncertainty, Springer, vol. 6(3), pages 255-75, June.
  9. Ondrej Rydval & Andreas Ortmann & Sasha Prokosheva & Ralph Hertwig, 2009. "How Certain Is the Uncertainty Effect?," CERGE-EI Working Papers wp385, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  10. Enrico Diecidue & Ulrich Schmidt & Peter P. Wakker, 2004. "The Utility of Gambling Reconsidered," Journal of Risk and Uncertainty, Springer, vol. 29(3), pages 241-259, December.
  11. John List, 2003. "Does market experience eliminate market anomalies?," Natural Field Experiments 00297, The Field Experiments Website.
  12. Slovic, Paul & Lichtenstein, Sarah, 1983. "Preference Reversals: A Broader Perspective," American Economic Review, American Economic Association, vol. 73(4), pages 596-605, September.
  13. Tversky, Amos & Kahneman, Daniel, 1986. "Rational Choice and the Framing of Decisions," The Journal of Business, University of Chicago Press, vol. 59(4), pages S251-78, October.
  14. Chris Starmer, 2000. "Developments in Non-expected Utility Theory: The Hunt for a Descriptive Theory of Choice under Risk," Journal of Economic Literature, American Economic Association, vol. 38(2), pages 332-382, June.
  15. Jonathan W. Leland, 1998. "Similarity Judgments in Choice Under Uncertainty: A Reinterpretation of the Predictions of Regret Theory," Management Science, INFORMS, vol. 44(5), pages 659-672, May.
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