Cognitive Imprecision and Stake-Dependent Risk Attitudes / 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. w30417.

NBER working paper series no. w30417

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2022.

Summary:

In an experiment that elicits subjects' willingness to pay (WTP) for the outcome of a lottery, we document a systematic effect of stake sizes on the magnitude and sign of the relative risk premium, and find that there is a log-linear relationship between the monetary payoff of the lottery and WTP, conditional on the probability of the payoff and its sign. We account quantitatively for this relationship, and the way in which it varies with both the probability and sign of the lottery payoff, in a model in which all departures from risk-neutral bidding are attributed to an optimal adaptation of bidding behavior to the presence of cognitive noise. Moreover, the cognitive noise required by our hypothesis is consistent with patterns of bias and variability in judgments about numerical magnitudes and probabilities that have been observed in other contexts. We thus provide foundations for the kind of nonlinear distortions in lottery valuation posited by prospect theory, that we believe can provide an interpretation for the observed instability across contexts of estimated prospect-theoretic parameters.

Notes:

Print version record

September 2022.