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Risk and Rationality:The Relative Importance of Probability Weighting and Choice Set Dependence

Adrian Bruhin, Maha Manai and Luis Santos-Pinto ()

Cahiers de Recherches Economiques du Département d'économie from Université de Lausanne, Faculté des HEC, Département d’économie

Abstract: The literature suggests that probability weighting and choice set dependence influence risky choices. However, their relative importance has not been tested jointly.We present a joint test that uses binary choices between lotteries provoking Common Consequence and Common Ratio Allais Paradoxes and manipulates their correlation structure. We show non-parametrically that probability weighting and choice set dependence both play a role at describing aggregate choices. To parsimoniously account for heterogeneity, we also estimate a structural model using a finite mixture approach.The model uncovers substantial heterogeneity and classifies subjects into three types: 38% Prospect Theory types whose choices are predominantly driven by probability weighting, 34% Salience Theory types whose choices are predominantly driven by choice set dependence, and 28% Expected Utility Theory types. The model predicts typespecific dierences in the frequency of preference reversals out-of-sample. Moreover, the out-of-sample predictions indicate that the choice context shapes the influence of choice set dependence.

Keywords: Choice under Risk; Choice Set Dependence; Probability Weighting; Salience Theory; Prospect Theory; Preference Reversals (search for similar items in EconPapers)
JEL-codes: C49 C91 D81 (search for similar items in EconPapers)
Pages: 115 pp.
Date: 2019-08
New Economics Papers: this item is included in nep-upt
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Citations: View citations in EconPapers (2) Track citations by RSS feed

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