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Risk and Rationality: Uncovering Heterogeneity in Probability Distortion

Author

Listed:
  • Adrian Bruhin

    () (Socioeconomic Institute, University of ZurichAuthor-Name: Helga Fehr)

  • Helga Fehr-Duda

    () (Institute of Economic Research, Swiss Federal Institute of Technology Zurich)

  • Thomas Epper

    () (Institute of Economic Research, Swiss Federal Institute of Technology Zurich)

Abstract

It has long been recognized that there is considerable heterogeneity in individual risk taking behavior but little is known about the distribution of risk taking types. We present a parsimonious characterization of risk taking behavior by estimating a finite mixture regression model for three different experimental data sets, two Swiss and one Chinese, over a large number of real gains and losses. We find two distinct types of individuals: In all three data sets, the choices of roughly 80% of the subjects exhibit significant deviations from rational probability weighting consistent with prospect theory. 20% of the subjects weight probabilities linearly and behave essentially as expected value maximizers. Moreover, the individuals are assigned to one of these two groups with probabilities of close to one resulting in a low measure of entropy. The reliability and robustness of our classification suggest using a mix of preference theories in applied economic modeling.

Suggested Citation

  • Adrian Bruhin & Helga Fehr-Duda & Thomas Epper, 2007. "Risk and Rationality: Uncovering Heterogeneity in Probability Distortion," SOI - Working Papers 0705, Socioeconomic Institute - University of Zurich, revised Jul 2007.
  • Handle: RePEc:soz:wpaper:0705
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    File URL: http://www.econ.uzh.ch/static/wp_soi/wp0705.pdf
    File Function: Revised version, 2007
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    References listed on IDEAS

    as
    1. El-Gamal, Mahmoud A. & Grether, David M., 1995. "Are People Bayesian? Uncovering Behavioral Strategies," Working Papers 919, California Institute of Technology, Division of the Humanities and Social Sciences.
    2. Urs Fischbacher, 2007. "z-Tree: Zurich toolbox for ready-made economic experiments," Experimental Economics, Springer;Economic Science Association, vol. 10(2), pages 171-178, June.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    individual risk taking behavior; latent heterogeneity; finite mixture regression models;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • C49 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Other

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