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Risk and Rationality: Uncovering Heterogeneity in Probability Distortion

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  • Adrian Bruhin

    () (Socioeconomic Institute, University of ZurichAuthor-Name: Helga Fehr)

  • Helga Fehr-Duda

    () (Institute of Economic Research, Swiss Federal Institute of Technology Zurich)

  • Thomas Epper

    () (Institute of Economic Research, Swiss Federal Institute of Technology Zurich)

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
File Function: Revised version, 2007
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Bibliographic 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
Publication status: published in Econometrica 78(4), pp. 1375-1412, 2010
Handle: RePEc:soz:wpaper:0705

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

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  1. El-Gamal, Mahmoud A. & Grether, David M., 1995. "Are People Bayesian? Uncovering Behavioral Strategies," Working Papers 919, California Institute of Technology, Division of the Humanities and Social Sciences.
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