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Risk and Rationality: Uncovering Heterogeneity in Probability Distortion

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Author Info
Adrian Bruhin () (Socioeconomic Institute, University of ZurichAuthor-Name: Helga Fehr)
Thomas Epper () (Institute of Economic Research, Swiss Federal Institute of Technology Zurich)

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Abstract

It has long been recognized that there is considerable heterogeneity in individual risk taking behavior but little is known about the distribution of risk taking types. We present a parsimonious characterization of risk taking behavior by estimating a finite mixture regression model for three different experimental data sets, two Swiss and one Chinese, over a large number of real gains and losses. We find two distinct types of individuals: In all three data sets, the choices of roughly 80% of the subjects exhibit significant deviations from rational probability weighting consistent with prospect theory. 20% of the subjects weight probabilities linearly and behave essentially as expected value maximizers. Moreover, the individuals are assigned to one of these two groups with probabilities of close to one resulting in a low measure of entropy. The reliability and robustness of our classification suggest using a mix of preference theories in applied economic modeling.

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File URL: http://www.soi.uzh.ch/research/wp/2007/wp0705.pdf
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File Function: Revised version, 2007
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Publisher Info
Paper provided by University of Zurich, Socioeconomic Institute in its series Working Papers with number 0705.

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Length: 29 pages
Date of creation: Mar 2007
Date of revision: Jul 2007
Handle: RePEc:soz:wpaper:0705

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Related research
Keywords: individual risk taking behavior latent heterogeneity finite mixture regression models

Other versions of this item:

Find related papers by JEL classification:
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
C49 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Other

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  1. Dennis Gaertner, 2007. "Monopolistic Screening under Learning By Doing," Working Papers 0718, University of Zurich, Socioeconomic Institute. [Downloadable!]
  2. Helga Fehr-Duda & Adrian Bruhin & Thomas Epper & Renate Schubert, 2007. "Rationality on the Rise: Why Relative Risk Aversion Increases with Stake Size," Working Papers 0708, University of Zurich, Socioeconomic Institute, revised Feb 2008. [Downloadable!]
  3. Daniel Halbheer & Ernst Fehr & Lorenz Goette & Armin Schmutzler, 2007. "Self-Reinforcing Market Dominance," Working Papers 0711, University of Zurich, Socioeconomic Institute. [Downloadable!]
  4. Rafael Lalive & Armin Schmutzler, 2005. "Exploring the Effects of Competition for Railway Markets," Working Papers 0511, University of Zurich, Socioeconomic Institute, revised Apr 2007. [Downloadable!]
  5. Stefan Boes, 2007. "Nonparametric Analysis of Treatment Effects in Ordered Response Models," Working Papers 0709, University of Zurich, Socioeconomic Institute. [Downloadable!]
  6. Dennis Gaertner, 2007. "Why Bayes Rules: A Note on Bayesian vs. Classical Inference in Regime Switching Models," Working Papers 0719, University of Zurich, Socioeconomic Institute. [Downloadable!]
  7. Lukas Steinmann & Harry Telser & Peter Zweifel, 2005. "The Impact of Aging on Future Healthcare Expenditure," Working Papers 0510, University of Zurich, Socioeconomic Institute, revised Dec 2006. [Downloadable!]
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