Can Climate Shocks Make Vulnerable Subjects More Willing to Take Risks?

While economists in the past tended to assume that individual preferences, including risk preferences, are stable over time, a recent literature has developed and indicates that risk preferences respond to shocks, with mixed evidence on the direction of the responses. This paper utilizes a natural experiment with covariate (drought) and idiosyncratic shocks in combination with an independent field risk experiment. The risk experiment uses a Certainty Equivalent-Multiple Choice List approach and is played 1–2 years after the subjects were (to a varying degree) exposed to a covariate drought shock or idiosyncratic shocks for a sample of resource-poor young adults living in a risky semi-arid rural environment in Sub-Saharan Africa. The experimental approach facilitates a comprehensive assessment of shock effects on experimental risk premiums for risky prospects with varying probabilities of good and bad outcomes. The experiment also facilitates the estimation of the utility curvature in an Expected Utility (EU) model and, alternatively, separate estimation of probability weighting and utility curvature in three different Rank Dependent Utility models with a two-parameter Prelec probability weighting function. Our study is the first to comprehensively test the theoretical predictions of Gollier and Pratt (Econom J Econom Soc 64:1109–1123, 1996) versus Quiggin (Econ Theor 22(3):607–611, 2003). Gollier and Pratt (1996) build on EU theory and state that an increase in background risk will make subjects more risk averse while Quiggin (2003) states that an increase in background risk can enhance risk-taking in certain types of non-EU models. We find strong evidence that such non-EU preferences dominate in our sample.