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Measuring Risk Aversion and the Wealth Effect

  • Heinemann, Frank

Measuring risk aversion is sensitive to assumptions about the wealth in subjects’ utility functions. Data from the same subjects in low- and high-stake lottery decisions allow estimating the wealth in a pre-specified one-parameter utility function simultaneously with risk aversion. This paper first shows how wealth estimates can be identified assuming constant relative risk aversion (CRRA). Using the data from a recent experiment by Holt and Laury (2002), it is shown that most subjects’ behavior is consistent with CRRA at some wealth level. However, for realistic wealth levels most subjects’ behavior implies a decreasing relative risk aversion. An alternative explanation is that subjects do not fully integrate their wealth with income from the experiment. Within-subject data do not allow discriminating between the two hypotheses. Using between-subject data, maximum-likelihood estimates of a hybrid utility function indicate that aggregate behavior can be described by expected utility from income rather than expected utility from final wealth and partial relative risk aversion is increasing in the scale of payoffs.

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File URL: http://epub.ub.uni-muenchen.de/13395/1/156.pdf
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Paper provided by Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich in its series Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems with number 156.

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Date of creation: Sep 2005
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Handle: RePEc:trf:wpaper:156
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  1. Gneezy, Uri & Potters, Jan, 1997. "An Experiment on Risk Taking and Evaluation Periods," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 631-45, May.
  2. Laura Schechter, 2007. "Risk aversion and expected-utility theory: A calibration exercise," Journal of Risk and Uncertainty, Springer, vol. 35(1), pages 67-76, August.
  3. Charles A. Holt & Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, American Economic Association, vol. 92(5), pages 1644-1655, December.
  4. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
  5. Matthew Rabin & Richard H. Thaler, 2001. "Anomalies: Risk Aversion," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 219-232, Winter.
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