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Reconsidering the common ratio effect: The roles of compound independence, reduction, and coalescing

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  • Ulrich Schmidt
  • Christian Seidl

Abstract

Common ratio effects should be ruled out if subjects' preferences satisfy compound independence, reduction of compound lotteries, and coalescing. In other words, at least one of these axioms should be violated in order to generate a common ratio effect. Relying on a simple experiment, we investigate which failure of these axioms is concomitant with the empirical observation of common ratio effects.We observe that compound independence and reduction of compound lotteries hold, whereas coalescing is systematically violated. This result provides support for theories which explain the common ratio effect by violations of coalescing (i.e., configural weight theory) instead of violations of compound independence (i.e., rank-dependent utility or cumulative prospect theory)

Suggested Citation

  • Ulrich Schmidt & Christian Seidl, 2014. "Reconsidering the common ratio effect: The roles of compound independence, reduction, and coalescing," Kiel Working Papers 1930, Kiel Institute for the World Economy.
  • Handle: RePEc:kie:kieliw:1930
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    More about this item

    Keywords

    common ratio effect; coalescing; reduction; compound independence; event splitting; branch splitting; isolation effect; Allais paradox;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • C44 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Operations Research; Statistical Decision Theory
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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