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Cognitive Imprecision and Small-Stakes Risk Aversion

Mel Win Khaw, Ziang Li and Michael Woodford ()

No 24978, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Observed choices between risky lotteries are difficult to reconcile with expected utility maximization, both because subjects appear to be too risk averse with regard to small gambles for this to be explained by diminishing marginal utility of wealth, as stressed by Rabin (2000), and because subjects' responses involve a random element. 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 representations of the decision situation. In this model, risk aversion results from a sort of perceptual bias—but one that represents an optimal decision rule, given the limitations of the mental representation of the situation. We propose a quantitative model of the noisy mental representation of simple lotteries, based on other evidence regarding numerical cognition, and test its ability to explain the choice frequencies that we observe in a laboratory experiment.

JEL-codes: C91 D03 D81 D87 (search for similar items in EconPapers)
Date: 2018-08
New Economics Papers: this item is included in nep-exp and nep-upt
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Published as Mel Win Khaw & Ziang Li & Michael Woodford, 2021. "Cognitive Imprecision and Small-Stakes Risk Aversion," The Review of Economic Studies, vol 88(4), pages 1979-2013.

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