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Measuring Risk Aversion and the Wealth Effect

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  • Heinemann, Frank

Abstract

Measuring risk aversion is sensitive to assumptions about the wealth in subjects’ utility functions. Data from the same subjects in low- and high-stake lottery decisions allow estimating the wealth in a pre-specified one-parameter utility function simultaneously with risk aversion. This paper first shows how wealth estimates can be identified assuming constant relative risk aversion (CRRA). Using the data from a recent experiment by Holt and Laury (2002), it is shown that most subjects’ behavior is consistent with CRRA at some wealth level. However, for realistic wealth levels most subjects’ behavior implies a decreasing relative risk aversion. An alternative explanation is that subjects do not fully integrate their wealth with income from the experiment. Within-subject data do not allow discriminating between the two hypotheses. Using between-subject data, maximum-likelihood estimates of a hybrid utility function indicate that aggregate behavior can be described by expected utility from income rather than expected utility from final wealth and partial relative risk aversion is increasing in the scale of payoffs.

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Paper provided by Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich in its series Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems with number 156.

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Date of creation: Sep 2005
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Handle: RePEc:trf:wpaper:156

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Keywords: lottery choice; risk aversion; myopic risk aversion;

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References

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  1. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  2. Gneezy, Uri & Potters, Jan, 1997. "An Experiment on Risk Taking and Evaluation Periods," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(2), pages 631-45, May.
  3. Charles A. Holt & Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, American Economic Association, American Economic Association, vol. 92(5), pages 1644-1655, December.
  4. Laura Schechter, 2007. "Risk aversion and expected-utility theory: A calibration exercise," Journal of Risk and Uncertainty, Springer, Springer, vol. 35(1), pages 67-76, August.
  5. Matthew Rabin & Richard H. Thaler, 2001. "Anomalies: Risk Aversion," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 15(1), pages 219-232, Winter.
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Cited by:
  1. Johansson-Stenman, Olof, 2009. "Risk Aversion and Expected Utility of Consumption over Time," Working Papers in Economics, University of Gothenburg, Department of Economics 351, University of Gothenburg, Department of Economics.
  2. Johansson-Stenman, Olof, 2006. "A Note on the Risk Behavior and Death of Homo Economicus," Working Papers in Economics, University of Gothenburg, Department of Economics 221, University of Gothenburg, Department of Economics.
  3. Booij, Adam S. & van Praag, Bernard M.S., 2009. "A simultaneous approach to the estimation of risk aversion and the subjective time discount rate," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 70(1-2), pages 374-388, May.

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