The Choice of Institutions: The Role of Risk and Risk-Aversion

22 Pages Posted: 24 Aug 2005

See all articles by Diana Weinhold

Diana Weinhold

London School of Economics & Political Science (LSE) - Department of International Development

Paul J. Zak

Claremont Graduate University - Center for Neuroeconomics Studies

Date Written: August 5, 2005

Abstract

Institutions can affect individual behavior both via their efficiency impact and via their risk reducing mechanisms. However there has been little study of the relative importance of these two channels in how individuals choose between simultaneously extant institutions. This paper presents a simple model of institutional choice in a labor market when there is a risk/reward trade-off, and tests the predictions of the theory. Using a novel empirical approach that adapts an ARCH-in-mean to cross-sectional survey data from China, we find that risk and risk aversion are strongly related to the choice of a labor market institution. Further, risk and risk aversion are quantitatively more important than the sectoral wage differential in explaining employment institution choices. Specifically, we find that wage risk has two orders of magnitude greater impact on labor market institutional choice than the wage difference, with a one standard deviation increase in earnings risk reducing the number of workers choosing jobs in the private (risky) sector by 22%.

Keywords: Institutions, Risk, Labor Market, Risk Aversion

JEL Classification: P3, J21, J40

Suggested Citation

Weinhold, Diana and Zak, Paul J., The Choice of Institutions: The Role of Risk and Risk-Aversion (August 5, 2005). Available at SSRN: https://ssrn.com/abstract=784765 or http://dx.doi.org/10.2139/ssrn.784765

Diana Weinhold (Contact Author)

London School of Economics & Political Science (LSE) - Department of International Development ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
(44) 171-955-6331 (Phone)

Paul J. Zak

Claremont Graduate University - Center for Neuroeconomics Studies ( email )

160 E. 10th St.
Claremont, CA 91711-6165
United States

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