Risk Aversion as a Perceptual Bias

47 Pages Posted: 8 May 2017

See all articles by Mel Khaw

Mel Khaw

Duke University

Ziang Li

Columbia University

Michael Woodford

Columbia Business School - Economics Department

Multiple version iconThere are 3 versions of this paper

Date Written: April 04, 2017

Abstract

The theory of expected utility maximization (EUM) proposed by Bernoulli explains risk aversion as a consequence of 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.

JEL Classification: C910, D800, D810, D870

Suggested Citation

Khaw, Mel Win and Li, Ziang and Woodford, Michael, Risk Aversion as a Perceptual Bias (April 04, 2017). CESifo Working Paper Series No. 6416, Available at SSRN: https://ssrn.com/abstract=2964856

Mel Win Khaw

Duke University ( email )

B355, 308 Research Dr
Durham, NC 27607
United States

Ziang Li

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

Michael Woodford (Contact Author)

Columbia Business School - Economics Department ( email )

420 West 118th Street
New York, NY 10027
United States

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