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Risk Aversion as a Perceptual Bias

Mel Win Khaw, Ziang Li and Michael Woodford ()

No 11929, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: The theory of expected utility maximization (EUM) explains risk aversion as due to 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.

Keywords: Bayesian decision theory; diminishing sensitivity; prospect theory; Rabin critique; Weber's Law (search for similar items in EconPapers)
JEL-codes: C91 D03 D81 D87 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-exp and nep-upt
Date: 2017-03
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