Essays on Individual Decision Making under Risk and Uncertainty (original) (raw)

Experimental economics and the theory of decision making under risk and uncertainty

The GENEVA Papers on Risk and Insurance-Theory, 2002

Following a brief review of the main experimental work into the economics of risk and uncertainty, both static and dynamic, this paper reports the results of an experiment testing one of the key assumptions of the theory of dynamic economic behaviour -that people have a plan and implement it. Using a unique design which enables the plan (if one exists) to be revealed by the first move, the experiment was implemented via the Internet on a subset of the University of Tilburg's ongoing family expenditure survey panel. The advantages of using such a set of subjects for the experiment are twofold: the demographic characteristics of the set are known and therefore demographic inferences can be made; the representativeness of the set is known and therefore inferences about populations can be made. The results suggest that at least 36% of the subjects had behaviour inconsistent with the hypothesis under test: that people formulate plans and then implement them. Interestingly demographic variables are unable to explain the consistency or inconsistency of individuals. One conclusion is that subjects simply make errors. An alternative conclusion, consistent with previous experimental research, is that people are unable to predict their own future decisions. The implications for dynamic theory (particularly relating to savings and pensions decisions) are important.

Essays on Decision Making under Uncertainty

2015

Professor Moshe Buchinsky, Co-chair Professor William R. Zame, Co-chair This dissertation consists of three chapters about decision making under uncertainty. Chapter 1: "Testing between Models of Smoking Risk Perceptions" Research in social and health psychology reports that smokers systematically underestimate the personal smoking risk. I build a model that captures potential determinants of smoking risk perceptions to investigate how smoking may cause an underestimation of the risk. The model is based on the premise that smokers have an incentive to be optimistic: because quitting may be hard, they find it reassuring to think that smoking is not so risky. Drawing upon the theoretical framework, I suggest two empirical tests of the model-one using survey data and another based on a laboratory experiment. iii Chapter 2: "Does Uncertainty Cause Inertia in Decision Making? An Experimental Study of the Role of Regret Aversion and Indecisiveness" Previous research has shown that in many situations there is clear inertia in individual decision making-that is, a tendency for decision makers to choose a status quo option. The status quo option may be the result of a previous choice, or may simply be the option designated as the "default." While inertia may simply reflect the fact that individuals view the status quo option as optimal, there are other factors that may explain this observed behavior. I conduct a laboratory experiment to thoroughly investigate two potential determinants of inertia in uncertain environments: (i) regret aversion and (ii) indecisiveness. A decision maker may experience regret when the outcome of a choice compares unfavorably to the outcome that would have occurred had she made a different choice. Alternatively, a decision maker may be indecisive among the options if she does not know the probability distributions over the relevant outcomes. I use a between-subjects design, with varying conditions, to identify the effects of regret aversion and indecisiveness on choice behavior. In each condition, participants choose between two simple real gambles, one of which is assigned to be the status quo. I find that inertia is quite large and that both mechanisms are equally important. Chapter 3: "Risk, Ambiguity, and Diversification" Attitudes toward risk influence the decision to diversify among uncertain options. Yet, because in most situations the probability distributions over outcomes are unknown, attitudes toward ambiguity may also play an important role. In a simple laboratory experiment, I investigate the effect of ambiguity on the decision to diversify. Participants have the opportunity to diversify between gambles; in one condition, all gambles are risky, whereas in the other all gambles are iv ambiguous. I find that diversification is more prevalent and more persistent under ambiguity than under risk. Moreover, excess diversification under ambiguity is driven by participants who stick with a status quo gamble when diversification is not feasible. This behavioral pattern cannot be accommodated by major theories of choice under ambiguity. v The dissertation of Santiago Ignacio Sautua is approved.

A Behavioral Perspective of Decision Making Under Risk and Uncertainty

The global financial crisis that began in 2007 was not predicted by standard economic theory which assumes rational actors, efficient markets and equilibrium. Alternative explanations of economic behavior that are based on psychological regularities which are observed in human behavior were until recently relegated to the fringes of the discourse regarding economic phenomena. It will be argued that this has proven to have been a mistake. Psychology has a long history in economic thought, but its influence on economic theory has ebbed and flowed over the years. Keynes had important psychological insights, but they have not been focused upon sufficiently in the last decades. Since the late 1970´s, though, new theories have emerged that are behavioral in nature. That is, they attempt to explain economic phenomena by being based on empirically observed psychological regularities of human behavior. This paper will show that psychology needs to be taken into consideration when reasoning about economic phenomena. The assumption of rationality that is prevalent in much of economic theory is based on a series of axioms and assumptions that are unrealistic. It will be argued that when reasoning about economic phenomena, that theory should be adopted which has more empirical support. The findings are that adopting a behavioral perspective of decision making has more explanatory and predictive power.

The hunt for a descriptive theory of choice under risk—A view from the road not taken

The Journal of Socio-Economics, 2010

In this paper I propose that the development of descriptive theories of choice in economics has been profoundly influenced by an arbitrary and seemly innocuous decision as to how to present risky choices to experimental subjects. This decision to represent lotteries as prospects has lead to a preoccupation with the question of whether preferences conform to what is known as the "independence axiom." Had the profession chosen to represent lotteries in the action-by-state matrices favored by Savage, the independence axiom would have appeared uncontroversial but we would have questioned whether preferences obeyed arguably more fundamental tenets of rationality like transitivity. That different ways of representing lotteries lead to different conclusions regarding which axioms preferences do and don't obey suggests that the choices people make aren't necessarily reflecting properties of their preferences at all. Instead the choices reveal properties of the decision rule individuals use to try to satisfy their preferences-a rule that involves judgments regarding the similarity or dissimilarity of prizes and their associated payoffs across alternatives. The paper discusses how such judgments explain observed behaviors given both prospect and matrix representations of lottery choices as well as explaining anomalies in other choice domains.

Economics versus Psychology. Risk, Uncertainty and the Expected Utility Theory

Economics versus Psychology. Risk, Uncertainty and the Expected Utility Theory, 2017

The present contribution examines the emergence of expected utility theory by John von Neumann and Oskar Morgenstern, the subjective the expected utility theory by Savage, and the problem of choice under risk and uncertainty, focusing in particular on the seminal work " The Utility Analysis of Choices involving Risk " (1948) by Milton Friedman and Leonard Savage to show how the evolution of the theory of choice has determined a separation of economics from psychology.

Foundations of Economic Psychology: A Behavioral and Mathematical Approach

2019

Keywords Expected value • Expected utility theory • St. Petersburg paradox • Ellsberg's paradox • Allais paradox Although economic behavior is often exhibited under conditions of uncertainty, we can decide future behavior to a certain extent by assigning a probability value to the uncertainty of the future. A situation is "under risk" when the probability of the future is known, and it is "under uncertainty" when the probability of the result is unknown. In this chapter, we examine the problem of decision making on the basis of the expected value in decision making under risk and propose expected utility theory as its solution. Expected utility theory has a long history that dates back to the 18th century and has a close relationship with economic psychology. In this chapter, we explain the basic idea of the original expected utility theory, explain the theories (e.g., the axiomatic system of expected utility theory), and introduce the economic psychological study of utility measurement on the basis of expected utility theory. 3.1 Decision Making Problems Based on Expected Values and Expected Utility Theory