Controlling for the Compromise Effect Debiases Estimates of Risk Preference Parameters

Abstract

The compromise effect arises when options near the "middle" of a choice set are more appealing. The compromise effect poses conceptual and practical problems for economic research: by influencing choices, it distorts revealed preferences, biasing researchers' inferences about deep (i.e., domain general) preferences. We propose and estimate an econometric model that disentangles and identifies both deep preferences and the context-dependent compromise effect. We demonstrate our method using data from an experiment with 550 participants who made choices over lotteries from multiple price lists. Following prior work, we manipulate the compromise effect by varying the middle options of each multiple price list and then estimate risk preferences without modelling the compromise effect. These naïve parameter estimates are not robust: they change as the compromise effect is manipulated. To eliminate this bias, we incorporate the compromise effect directly into our econometric model. We show that this method generates robust estimates of risk preference parameters that are no longer sensitive to compromise-effect manipulations. This method can be applied to other settings that exhibit the compromise effect.

Keywords: compromise effect, cumulative prospect theory, loss aversion, risk preferences

JEL Classification: B49, D03, D14, D83, G11