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Psychophysical laws in risk theory

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  • Sinn, Hans-Werner

Abstract

In this article specific hypotheses on the shape of a rational agent’s risk preference function are derived from psychophysical laws. Weber’s law is used to establish the hypothesis of constant relative risk aversion for a myopic expected-utility maximizer. Weber’s law. Fechner’s law and a modified version of Koopmans’ preference functional are shown to generate a family of multiperiod preference functionals which are either of an additive logarithmic or a multiplicative Cobb-DougIas type. This family has very appealing implications in a world of stochastic constant returns to scale. For the actual decision the multiperiod optimizer exhibits constant relative risk aversion as does the myopic optimizer. However, with the passage of time. the degree of this risk aversion, in general, moves towards unity. Moreover, it is worth noting that the agent neither has to make the consumption decision simultaneously with the selection of an optimal risk project nor needs any information about the future except his or her own preferences.

Suggested Citation

  • Sinn, Hans-Werner, 1985. "Psychophysical laws in risk theory," Munich Reprints in Economics 19903, University of Munich, Department of Economics.
    • Handle: RePEc:lmu:muenar:19903
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    Cited by:

    1. Denis Conniffe, 2007. "The Generalised Extreme Value Distribution as Utility Function," The Economic and Social Review, Economic and Social Studies, vol. 38(3), pages 275-288.
    2. Hans-Werner Sinn, 2003. "Weber's Law and the Biological Evolution of Risk Preferences: The Selective Dominance of the Logarithmic Utility Function, 2002 Geneva Risk Lecture," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 28(2), pages 87-100, December.
    3. Robison, Lindon J., 1994. "Expanding The Set Of Expected Utility And Mean Standard Deviation Consistent Models," 1994 Quantifying Long Run Agricultural Risks and Evaluating Farmer Responses Risk, Technical Committee Meeting, March 24-26, 1994, Gulf Shores State Park, Alabama 271676, Regional Research Projects > S-232: Quantifying Long Run Agricultural Risks and Evaluating Farmer Responses to Risk.
    4. Koford, Kenneth & Tschoegl, Adrian E., 1998. "The market value of rarity," Journal of Economic Behavior & Organization, Elsevier, vol. 34(3), pages 445-457, March.

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