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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

The literature suggests that probability weighting and choice set dependence influence risky choices. However, their relative importance has not been tested jointly.We present a joint test that uses binary choices between lotteries provoking Common Consequence and Common Ratio Allais Paradoxes and manipulates their correlation structure. We show non-parametrically that probability weighting and choice set dependence both play a role at describing aggregate choices. To parsimoniously account for heterogeneity, we also estimate a structural model using a finite mixture approach.The model uncovers substantial heterogeneity and classifies subjects into three types: 38% Prospect Theory types whose choices are predominantly driven by probability weighting, 34% Salience Theory types whose choices are predominantly driven by choice set dependence, and 28% Expected Utility Theory types. The model predicts typespecific dierences in the frequency of preference reversals out-of-sample. Moreover, the out-of-sample predictions indicate that the choice context shapes the influence of choice set dependence.

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  • Adrian Bruhin & Maha Manai & Luis Santos-Pinto, 2019. "Risk and Rationality:The Relative Importance of Probability Weighting and Choice Set Dependence," Cahiers de Recherches Economiques du Département d'économie 19.05, Université de Lausanne, Faculté des HEC, Département d’économie.
  • Handle: RePEc:lau:crdeep:19.05
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    More about this item

    Keywords

    Choice under Risk; Choice Set Dependence; Probability Weighting; Salience Theory; Prospect Theory; Preference Reversals;
    All these keywords.

    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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