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Probability and Time Trade-Off

Author

Listed:
  • Manel Baucells

    (Universitat Pompeu Fabra and Barcelona GSE, Ramon Trias Fargas 25-27, 08005 Barcelona, Spain)

  • Franz H. Heukamp

    (IESE Business School, Avda. Pearson 21, 08034 Barcelona, Spain)

Abstract

Probability and time are integral dimensions of virtually any decision. To treat them together, we consider the prospect of receiving outcome x with a probability p at time t . We define risk and time distance, and show that if these two distances are traded off linearly, then preferences are characterized by three functions: a value function, a probability discount rate function, and a psychological distance function. The concavity of the psychological distance function explains the common ratio and common difference effects. A decreasing probability discount rate accounts for the magnitude effect. The discount rate and the risk premium depend on the shape of these three functions. This paper was accepted by Peter Wakker, decision analysis.

Suggested Citation

  • Manel Baucells & Franz H. Heukamp, 2012. "Probability and Time Trade-Off," Management Science, INFORMS, vol. 58(4), pages 831-842, April.
    • Handle: RePEc:inm:ormnsc:v:58:y:2012:i:4:p:831-842
    DOI: 10.1287/mnsc.1110.1450
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    References listed on IDEAS

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