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Cognitive Imprecision and Stake-Dependent Risk Attitudes

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Listed:
  • Mel Win Khaw
  • Ziang Li
  • Michael Woodford

Abstract

In an experiment that elicits subjects’ willingness to pay (WTP) for the outcome of a lottery, we document a systematic effect of stake sizes on the magnitude and sign of the relative risk premium, and find that there is a log-linear relationship between the monetary payoff of the lottery and WTP, conditional on the probability of the payoff and its sign. We account quantitatively for this relationship, and the way in which it varies with both the probability and sign of the lottery payoff, in a model in which all departures from risk-neutral bidding are attributed to an optimal adaptation of bidding behavior to the presence of cognitive noise. Moreover, the cognitive noise required by our hypothesis is consistent with patterns of bias and variability in judgments about numerical magnitudes and probabilities that have been observed in other contexts. We thus provide foundations for the kind of nonlinear distortions in lottery valuation posited by prospect theory, that we believe can provide an interpretation for the observed instability across contexts of estimated prospect-theoretic parameters.

Suggested Citation

  • Mel Win Khaw & Ziang Li & Michael Woodford, 2022. "Cognitive Imprecision and Stake-Dependent Risk Attitudes," NBER Working Papers 30417, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:30417
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    More about this item

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D87 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Neuroeconomics

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