Risk Aversion: The Need for Behavioral Explanation(s)
51 Pages Posted: 23 Mar 2018 Last revised: 1 Apr 2018
Date Written: April 1, 2017
Expected utility theory (EUT) is a parsimonious theory that explains behavior under risk and uncertainty. Previous research showed that EUT of wealth is not a satisfactory explanation of risk aversion. We use empirical data from a controlled laboratory experiment to show that EUT of income cannot explain risk aversion either. The experimental data suggests that the marginal utility of money would decrease at an absurdly high rate if the concavity of Bernoulli utility function is used to explain risk aversion. We demonstrate that loss aversion together with probability weighting explain the observed risk aversion well. Unlike many previous studies, we elicit valuations-Willingness to Pay (WTP) and Willingness to Accept (WTA)-for risky prospects to make the reference points more salient. Using an empirical model that features reference-dependent preference, we further show that our identi cation is robust to changes in reference points. The obtained parameters from estimating the structural model are consistent with literature.
Keywords: Risk Aversion, Loss Aversion, Probability Weighting, Reference Dependence, Lottery
JEL Classification: D81, D84, D03
Suggested Citation: Suggested Citation