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Underestimation of probability modifications: characterization and economic implications

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  • Johanna Etner
  • Meglena Jeleva

Abstract

The aim of this paper is to propose a behavioral characterization of individuals who underestimate probability modifications and to characterize this behavior in the standard preferences representation models under risk (Expected utility, Dual theory, Rank Dependant Utility Theory and MaxMin Expected Utility). Our main results are the following. Underreaction to probability modifications is in general independent from standard risk aversion and prudence. In models involving probability transformation functions, it is characterized by the slope of the probability transformation function. In the MaxMin Expected utility model under risk, it is related to the weights of the maximal and minimal consequences in the preferences representation function. Considering a simple prevention decision, consisting in the reduction of the probability of a monetary loss, we show that individuals who underreact to probability modifications invest less in prevention than individuals who objectively evaluate these modifications. Underreaction to probability modification is thus a possible explanation for low investment in prevention.

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File URL: http://economix.fr/pdf/dt/2012/WP_EcoX_2012-33.pdf
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Bibliographic Info

Paper provided by University of Paris West - Nanterre la Défense, EconomiX in its series EconomiX Working Papers with number 2012-33.

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Length: 18 pages
Date of creation: 2012
Date of revision:
Handle: RePEc:drm:wpaper:2012-33

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Keywords: probability perception; non expected utility; prevention;

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  1. Adrian Bruhin & Helga Fehr-Duda & Thomas Epper, 2007. "Risk and Rationality: Uncovering Heterogeneity in Probability Distortion," SOI - Working Papers 0705, Socioeconomic Institute - University of Zurich, revised Jul 2007.
  2. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
  3. Louis Eeckhoudt & Christian Gollier, 2005. "The impact of prudence on optimal prevention," Economic Theory, Springer, vol. 26(4), pages 989-994, November.
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