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Reduction of Compound Lotteries with Objective Probabilities: Theory and Evidence

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  • Glenn W. Harrison
  • Jimmy Martínez-Correa
  • J. Todd Swarthout

Abstract

The reduction of compound lotteries (ROCL) has assumed a central role in the evaluation of behavior towards risk and uncertainty. We present experimental evidence on its validity in the domain of objective probabilities. Our experiment explicitly recognizes the impact that the random lottery incentive mechanism payment procedure may have on preferences, and so we collect data using both "1-in-1" and "1-in-K" payment procedures, where K>1. We do not find violations of ROCL when subjects are presented with only one choice that is played for money. However, when individuals are presented with many choices and random lottery incentive mechanism is used to select one choice for payoff, we do find violations of ROCL. These results are supported by both non-parametric analysis of choice patterns, as well as structural estimation of latent preferences. We find evidence that the model that best describes behavior when subjects make only one choice is the Rank-Dependent Utility model. When subjects face many choices, their behavior is better characterized by our source-dependent version of the Rank-Dependent Utility model which can account for violations of ROCL. We conclude that payment protocols can create distortions in experimental tests of basic axioms of decision theory.

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Bibliographic Info

Paper provided by Experimental Economics Center, Andrew Young School of Policy Studies, Georgia State University in its series Experimental Economics Center Working Paper Series with number 2012-04.

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Length: 100
Date of creation: Mar 2012
Date of revision:
Handle: RePEc:exc:wpaper:2012-04

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  1. Harless, David W., 1992. "Predictions about indifference curves inside the unit triangle : A test of variants of expected utility theory," Journal of Economic Behavior & Organization, Elsevier, vol. 18(3), pages 391-414, August.
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Cited by:
  1. Glenn W. Harrison & Jimmy Martínez-Correa & J. Todd Swarthout, 2012. "Eliciting Subjective Probabilities with Binary Lotteries," Experimental Economics Center Working Paper Series 2012-16, Experimental Economics Center, Andrew Young School of Policy Studies, Georgia State University.
  2. Drichoutis, Andreas & Nayga, Rodolfo, 2013. "A reconciliation of time preference elicitation methods," MPRA Paper 46916, University Library of Munich, Germany, revised 12 May 2013.
  3. Philip J. Grossman & Catherine C. Eckel, 2012. "Loving the Long Shot: Risk Taking with Skewed Lotteries," Development Research Unit Working Paper Series 41-12, Monash University, Department of Economics.
  4. David Dillenberger & Uzi Segal, 2013. "Skewed Noise," PIER Working Paper Archive 13-066, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  5. David Dillenberger & Uzi Segal, 2013. "Skewed Noise," Boston College Working Papers in Economics 843, Boston College Department of Economics.
  6. Cary Deck & Harris Schlesinger, 2012. "Consistency of Higher Order Risk Preferences," CESifo Working Paper Series 4047, CESifo Group Munich.
  7. Amalia Di Girolamo & Glenn W. Harrison & Morten I. Lau & J. Todd Swarthout, 2013. "Characterizing Financial and Statistical Literacy," Experimental Economics Center Working Paper Series 2013-04, Experimental Economics Center, Andrew Young School of Policy Studies, Georgia State University.

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