Risk and rationality: The relative importance of probability weighting and choice set dependence

The literature suggests that probability weighting and choice set dependence influence risky choices. However, their relative importance remains an open question. We present a joint test that uses binary choices between lotteries provoking Common Consequence and Common Ratio Allais Paradoxes and man...

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Bibliographic Details
Published inJournal of risk and uncertainty Vol. 65; no. 2; pp. 139 - 184
Main Authors Bruhin, Adrian, Manai, Maha, Santos-Pinto, Luís
Format Journal Article
LanguageEnglish
Published New York Springer US 01.10.2022
Springer Nature B.V
Subjects
Economic Theory/Quantitative Economics/Mathematical Methods
Economics
Economics and Finance
Environmental Economics
Expected utility
Heterogeneity
Lotteries
Microeconomics
Operations Research/Decision Theory
Payoffs
Preferences
Probability
Prospect theory
Rationality
Utility theory
Weighting
Prospect theory
Salience theory
Choice under risk
C49
Probability weighting
C91
Choice set dependence
D81
Preference reversals
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Summary:The literature suggests that probability weighting and choice set dependence influence risky choices. However, their relative importance remains an open question. We present a joint test that uses binary choices between lotteries provoking Common Consequence and Common Ratio Allais Paradoxes and manipulates their joint payoff distribution. We show non-parametrically that probability weighting and choice set dependence both play a role at describing aggregate choices. To parsimoniously account for heterogeneity, we also estimate a structural model using a finite mixture approach. The model uncovers substantial heterogeneity and classifies subjects into three types: 38% Prospect Theory types whose choices are predominantly driven by probability weighting, 34% Salience Theory types whose choices are predominantly driven by choice set dependence, and 28% Expected Utility Theory types. The model predicts type-specific differences in the frequency of preference reversals out-of-sample, i.e., in choices with a different context than the ones used for estimating the model. Moreover, the out-of-sample predictions indicate that the choice context shapes the influence of choice set dependence.
Bibliography:ObjectType-Article-1
SourceType-Scholarly Journals-1
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ISSN:0895-5646
1573-0476
DOI:10.1007/s11166-022-09392-x