The Uncertainty Effect: When a Risky Prospect is Valued Less than its Worst Possible Outcome
John List () and
The Quarterly Journal of Economics, 2006, vol. 121, issue 4, 1283-1309
Expected utility theory, prospect theory, and most other models of risky choice are based on the fundamental premise that individuals choose among risky prospects by balancing the value of the possible consequences. These models, therefore, require that the value of a risky prospect lie between the value of that prospect's highest and lowest outcome. Although this requirement seems essential for any theory of risky decision-making, we document a violation of this condition in which individuals value a risky prospect less than its worst possible realization. This demonstration, which we term the uncertainty effect, draws from more than 1000 experimental participants, and includes hypothetical and real pricing and choice tasks, as well as field experiments in real markets with financial incentives. Our results suggest that there are choice situations in which decision-makers discount lotteries for uncertainty in a manner that cannot be accommodated by standard models of risky choice. From the time of Bernoulli on, it has been common to argue that (a) individuals tend to display aversion to the taking of risks, and (b) that risk aversion in turn is an explanation for many observed phenomena in the economic world [Arrow 1971, p. 90].
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Persistent link: https://EconPapers.repec.org/RePEc:oup:qjecon:v:121:y:2006:i:4:p:1283-1309.
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