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On the Source and Instability of Probability Weighting

Author

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  • Cary Frydman
  • Lawrence J. Jin

Abstract

We propose and experimentally test a new theory of probability distortions in risky choice. The theory is based on a core principle from neuroscience called efficient coding, which states that information is encoded more accurately for those stimuli that the agent expects to encounter more frequently. As the agent's prior beliefs vary, the model predicts that probability distortions change systematically. We provide novel experimental evidence consistent with the prediction: lottery valuations are more sensitive to probabilities that occur more frequently under the subject's prior beliefs. Our theory generates additional novel predictions regarding heterogeneity and time variation in probability distortions.

Suggested Citation

  • Cary Frydman & Lawrence J. Jin, 2023. "On the Source and Instability of Probability Weighting," NBER Working Papers 31573, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:31573
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    Cited by:

    1. Benjamin Enke & Thomas Graeber & Ryan Oprea & Thomas W. Graeber, 2023. "Complexity and Hyperbolic Discounting," CESifo Working Paper Series 10861, CESifo.
    2. Benjamin Enke & Cassidy Shubatt, 2023. "Quantifying Lottery Choice Complexity," CESifo Working Paper Series 10644, CESifo.

    More about this item

    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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