Insurance and Probability Weighting Functions
AbstractEvidence shows that (i) people overweight low probabilities and underweight high probabilities, but (ii) ignore events of extremely low probability and treat extremely high probability events as certain. Decision models, such as rank dependent utility (RDU) and cumulative prospect theory (CP), use probability weighting functions. Existing probability weighting functions incorporate (i) but not (ii). Our contribution is threefold. First, we show that this would lead people, even in the presence of fixed costs and actuarially unfair premiums, to insure fully against losses of sufficiently low probability. This is contrary to the evidence. Second, we introduce a new class of probability weighting functions, which we call higher order Prelec probability weighting functions, that incorporate (i) and (ii). Third, we show that if RDU or CP are combined with our new probability weighting function, then a decision maker will not buy insurance against a loss of sufficiently low probability; in agreement with the evidence. We also show that our weighting function solves the St. Petersburg paradox that reemerges under RDU and CP.
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Bibliographic InfoPaper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number 05/19.
Date of creation: Jul 2005
Date of revision: Sep 2006
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Find related papers by JEL classification:
- C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
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- Ali al-Nowaihi & Sanjit Dhami, 2010. "Probability Weighting Functions," Discussion Papers in Economics, Department of Economics, University of Leicester 10/10, Department of Economics, University of Leicester.
Blog mentionsAs found by EconAcademics.org, the blog aggregator for Economics research:CitEc Project, subscribe to its RSS feed for this item.
- Sanjit Dhami & Ali al-Nowaihi, 2006. "Hang ’em with probability zero: Why does it not work?," Discussion Papers in Economics, Department of Economics, University of Leicester 06/14, Department of Economics, University of Leicester.
- Ali al-Nowaihi & Ian Bradley & Sanjit Dhami, 2006. "The Utility Function Under Prospect Theory," Discussion Papers in Economics, Department of Economics, University of Leicester 06/15, Department of Economics, University of Leicester.
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