Rationality on the Rise: Why Relative Risk Aversion Increases with Stake Size

How does risk tolerance vary with stake size? This important question cannot be adequately answered if framing effects, nonlinear probability weighting, and heterogeneity of preference types are neglected. We show that the increase in relative risk aversion over gains cannot be captured by the curvature of the utility function. It is driven predominantly by a change in probability weighting of a majority group of individuals who exhibit more rational probability weighting at high stakes. Contrary to gains, noncoherent change in relative risk aversion is observed for losses. These results not onlynchallenge expected utility theory, but also prospect theory

Risk and Rationality: Uncovering Heterogeneity in Probability Distortion

It has long been recognized that there is considerable heterogeneity in individual risk taking behavior but little is known about the distributionnof 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 exhibitnsignificant deviations from linear probability weighting, consistent with prospect theory. 20% of the subjects weight probabilities near linearly and behave essentially as expected value maximizers. Moreover, individuals are cleanly assigned to one type with probabilities close to unity. The reliability and robustness of our classification suggest using a mix of preference theories in applied economic modeling

Viewing the future through a warped lens: Why uncertainty generates hyperbolic discounting

Time preferences, Risk preferences, Hyperbolic discounting, Probability weighting, Institutionally generated uncertainty, D01, D81, D91,