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Risk and Rationality:The Relative Importance of Probability Weighting and Choice Set Dependence

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  • Adrian Bruhin
  • Maha Manai
  • Luis Santos-Pinto

Abstract

We analyze the relative importance of probability weighting and choice set dependence in describing risky choices both non-parametrically and with a structural model. Our experimental design uses binary choices between lotteries that may trigger Allais Paradoxes. We change the choice set by manipulating the correlation structure of the lotteries' payoffs while keeping their marginal distributions constant. This allows us to discriminate between probability weighting and choice set dependence. There are three main results. First, probability weighting and choice set dependence both play a role in describing aggregate choices. Second, the structural model uncovers substantial individual heterogeneity which can be parsimoniously characterized by three types: 38% of subjects engage primarily in probability weighting, 34% are in uenced predominantly by choice set dependence, and 28% are mostly rational. Third, the classification of subjects into types predicts preference reversals out-of-sample. These results may not only further our understanding of choice under risk but may also prove valuable for describing the behavior of consumers, investors, and judges.

Suggested Citation

  • Adrian Bruhin & Maha Manai & Luis Santos-Pinto, 2018. "Risk and Rationality:The Relative Importance of Probability Weighting and Choice Set Dependence," Cahiers de Recherches Economiques du Département d'économie 18.04, Université de Lausanne, Faculté des HEC, Département d’économie.
  • Handle: RePEc:lau:crdeep:18.04
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    Cited by:

    1. Markus Dertwinkel-Kalt & Mats Köster, 2018. "Salience and Skewness Preferences," CESifo Working Paper Series 7416, CESifo Group Munich.

    More about this item

    Keywords

    Individual Choice under Risk; Choice Set Dependence; Probability Weighting; Latent Heterogeneity; Preference Reversals;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • C49 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Other

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