Risk Aversion as a Perceptual Bias / Mel Win Khaw, Ziang Li, Michael Woodford.

Format:

Book

Author/Creator:

Khaw, Mel Win.

Contributor:

National Bureau of Economic Research.

Li, Ziang.

Woodford, Michael.

Series:

Working Paper Series (National Bureau of Economic Research) no. w23294.

NBER working paper series no. w23294

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2017.

Summary:

The theory of expected utility maximization (EUM) explains risk aversion as due to diminishing marginal utility of wealth. However, observed choices between risky lotteries are difficult to reconcile with EUM: for example, in the laboratory, subjects' responses on individual trials involve a random element, and cannot be predicted purely from the terms offered; and subjects often appear to be too risk averse with regard to small gambles (while still accepting sufficiently favorable large gambles) to be consistent with any utility-of-wealth function. We propose a unified explanation for both anomalies, similar to the explanation given for related phenomena in the case of perceptual judgments: they result from judgments based on imprecise (and noisy) mental representation of the decision situation. In this model, risk aversion is predicted without any need for a nonlinear utility-of-wealth function, and instead results from a sort of perceptual bias -- but one that represents an optimal Bayesian decision, given the limitations of the mental representation of the situation. We propose a specific quantitative model of the mental representation of a simple lottery choice problem, based on other evidence regarding numerical cognition, and test its ability to explain the choice frequencies that we observe in a laboratory experiment.

Notes:

Print version record

March 2017.