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Loss Aversion, Risk Aversion, and the Shape of the Probability Weighting Function

Author

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  • Matthew D. Rablen

    (Department of Economics, University of Sheffield, 9 Mappin Street, Sheffield, S1 4DT, UK.)

Abstract

Loss aversion, risk aversion, and the probability weighting function (PWF) are three central concepts in explaining decision making under risk. I examine interlinkages be- tween these concepts in a model of decision making that allows for loss averse/tolerant stochastic reference dependence and optimism/pessimism over probability distribu- tions. I give a preference interpretation to commonly observed shapes of PWF and to risk aversion. In particular, I establish a connection between loss aversion and both risk aversion and the inverse-S PWF: loss aversion is a necessary condition to observe each of these phenomena. The results extend to distinct PWFs in the gain and loss domains, as under prospect theory.

Suggested Citation

  • Matthew D. Rablen, 2023. "Loss Aversion, Risk Aversion, and the Shape of the Probability Weighting Function," Working Papers 2023013, The University of Sheffield, Department of Economics.
    • Handle: RePEc:shf:wpaper:2023013
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    File URL: https://www.sheffield.ac.uk/economics/research/serps
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    JEL classification:

    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles

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