Showing papers in "Journal of Risk and Uncertainty in 1989"

An Experimental Test of Several Generalized Utility Theories

Abstract: There is much evidence that people willingly violate expected utility theory when making choices. Several axiomatic theories have been proposed to explain some of this evidence, but there are few data that discriminate between the theories. To gather such data, an experiment was conducted using pairs of gambles with three levels of outcomes and many combinations of probabilities. Most typical findings were replicated, including the common consequence effect and different risk attitudes for gains and losses. There is evidence of both fanning out and fanning in of indifference curves, and both quasiconcavity and quasiconvexity of preferences. No theory can explain all the data, but prospect theory and the hypothesis that indifference curves fan out can explain most of them.

Prospective reference theory: Toward an explanation of the paradoxes

Abstract: This article develops a variant of the expected utility model termed prospective reference theory. Although the standard model occurs as a limiting case, the general approach is that individuals treat stated experimental probabilities as imperfect information. This model is applied to a wide variety of aberrant phenomena, including the Allais paradox, the overweighting of low-probability events, the existence of premiums for certain elimination of risks, and the representativeness heuristic. The prospective reference theory model predicts most of the observed behavioral patterns rather than being potentially reconcilable with such phenomena.

Risk, ambiguity, and insurance

Abstract: In a series of experiments, economically sophisticated subjects, including professional actuaries, priced insurance both as consumers and as firms under conditions of ambiguity. Findings support implications of the Einhorn-Hogarth ambiguity model: (1) For low probability-of-loss events, prices of both consumers and firms indicated aversion to ambiguity; (2) As probabilities of losses increased, aversion to ambiguity decreased, with consumers exhibiting ambiguity preference for high probability-of-loss events; and (3) Firms showed greater aversion to ambiguity than consumers. The results are shown to be incompatible with traditional economic analysis of insurance markets and are discussed with respect to the effects of ambiguity on the supply and demand for insurance.

Laboratory experiments with a finite-horizon job-search model

Abstract: In this article we explain the essential role of controlled experiments in testing job-search models. We derive the testable implications of a finite-horizon job-search model and lay out the design of the controlled experiments that we use to test those implications. We present the results of several parametric and nonparametric tests, all conditional on the actual draws of the wage offers. Overall, we find close agreement between the predictions of the search model and observations of search duration and income for several experimental treatments.

Probability and juxtaposition effects: An experimental investigation of the common ratio effect

Abstract: Several theories explain the common ratio effect as a probability effect resulting from properties of individuals' preference orderings over probability distributions of consequences. In contrast, regret theory explains it as the result of changes in the juxtaposition of consequences in the action/state matrix. This article reports an experiment that allowed probability effects and juxtaposition effects to be separately identified for some common ratio problems, some of which involved real gains and others, real losses. The main finding is that changes in the juxtaposition of consequences have systematic effects on choices in the direction predicted by regret theory.

Retrospective on the utility theory of von Neumann and Morgenstern

Abstract: This article offers an exegesis of the passages in von Neumann and Morgenstern (1944, 1947, 1953) that discuss their conception of utility. It is occasioned by two factors. First, as we approach the semicentennial of the publication of Theory of Games and Economic Behavior, its immense impact on economic thought in the intervening years encourages serious reflection on its authors' ideas. Second, misleading statements about the theory continue to appear. The article will have accomplished its purpose if it helps others appreciate the genius and spirit of the theory of utility fashioned by John von Neumann and Oskar Morgenstern.

Experimental Markets for Insurance

Abstract: This article extends the large amount of research on double-oral auction markets to hazards that produce only losses. We report results from a series of experiments in which subjects endowed with low-probability losses can pay a premium for insurance protection. Insurers specify the price at which they are willing to assume the risk of a loss. Insurance prices approach expected value for a large range of probabilities and loss amounts. Subjects seem to realize losses are statistically independent. Prices are not affected by ambiguity about the probability of loss.

Deterministic transformations of random variables and the comparative statics of risk

Abstract: In this article, a general class of deterministic transformations that can be interpreted as changes in risk are identified. This provides a fourth characterization of a Rothschild-Stiglitz increase in risk. In addition, a particular subclass of these transformations, termed simple transformations, is shown to be well suited for comparative static analyses. This subclass contains as a special case the linear transformation used so often in the literature. A theorem is presented that generalizes the known comparative static results for large as well as small changes in risk.

More on insurance as a Giffen good

Abstract: In this article, we generalize the Hoy and Robson (1981) analysis and provide a necessary and sufficient condition for insurance not to be a Giffen good. The condition gives a bound for the variation of absolute risk aversion that permits the wealth effect to be always dominated by the substitution effect.

Preferences for information on probabilities versus prizes: The role of risk-taking attitudes

Abstract: Many real-world decisions entail choices between information on either probabilities or payoffs (i.e., prizes). Simplified versions of such decisions are examined to gain insight into preferences for different types of information as a function of risk-attitudes. General and simple decision rules are derived for cases where the utility function is concave (or convex) over the relevant payoff interval. The article further describes several experiments to test business students' intuitions concerning these optimal decision rules. In general, risk-taking attitudes did not correlate significantly with subjects' preferences for information, in violation of theorems regarding mean-preserving spreads of risk. Other tests, e.g., narrowing certain probability ranges, also resulted in preferences contrary to expected utility (EU) theory. Behavioral and economic explanations are examined for people's limited insights into the value of information. The main experimental results are proved to be counter to subjective expected utility (SEU) theory as well as EU. Subjects appear to use heuristics in which probability is not treated linearly, second-order probability matters, and nonmultiplicative integration occurs with prizes.

Risk aversion and the relationship between Nash's solution and subgame perfect equilibrium of sequential bargaining

Abstract: This article presents some new, intuitive derivations of several results in the bargaining literature. These new derivations clarify the relationships among these results and allow them to be understood in a unified way. These results concern the way in which the risk posture of the bargainers affects the outcome of bargaining as predicted by Nash's (axiomatic) solution of a static bargaining model (Nash, 1950) and by the subgame perfect equilibrium of the infinite horizon sequential bargaining game analyzed by Rubinstein (1982). The analogous, experimentally testable predictions for finite horizon sequential bargaining games are also presented.

The impact of risk sharing on efficient decision

Abstract: A group of risk-averse members must choose among monetary risks and payoff-sharing rules. Departure from the status quo requires unanimous consent. Such groups drill for oil, bail out nations, and make hostile takeover bids. Assume agreement on probabilities. As is well known, if all members have identically shaped HARA utility functions, efficient group act-choices follow another such function independently of payoff sharing. We show that all other groups inevitably have complex efficient behavior, accepting gambles among individually unacceptable lotteries in almost every status quo position. We also develop proper risk aversion for groups, and treat disagreement on probabilities.

Adjusting risky situations: A theoretical framework and empirical test

Abstract: Experienced executives frequently try to modify the risky situations they face in order to make them more favorable rather than simply choosing from among available decision options. This article investigates several types of risk adjustments such as trying to influence the situation through bargaining and spending resources, gathering information, developing new options, and consulting one's superiors. A theoretical framework is presented that characterizes different types of adjustments and relates them to variables such as perceived risk, perceived control, perceived responsibility, decisiveness, and risky choice. The framework is tested using experienced decision makers who respond to four simulated risky business decisions.

Decision Analysis Using Lottery-Dependent Utility

Abstract: In this article we show how the lottery-dependent expected utility (LDEU) model can be used in decision analysis. The LDEU model is an extension of the classical expected utility (EU) model and yet permits preference patterns that are infeasible in the EU model. We propose a framework for constructing decision trees in a particular way that permits us to use the principle of optimality and thus the divide and conquer strategy for analyzing complex problems using the LDEU model. Our approach may be applicable to some other nonlinear utility models as well. The result is that, if desired, decision analysis can be conducted without assuming the restrictive substitution principle/independence axiom.

Adaptive learning, adaptive utility, and rational behavior in a repeated prisoner's dilemma

Abstract: Two dimensions of learning are explored in a repeated prisoner's dilemma experiment. Subject update their perceptions of the true model of their opponent's behavior. Subjects also update their beliefs Kraft Funds at the Fuqua School of Business, helpful comments by Robert Axelrod, Michael Cohen, Fred Feinberg, J. Keith Murnighan, Kip Viscusi, Bob Winkler, and two anonymous referees, and the programming assistance of Oris Stuart and Michael Guiry.

The effect of airline pilot characteristics on perceptions of job safety risks

Abstract: In a large cross-sectional sample, commercial airline pilots in the United States were asked for their perceptions of job safety hazards. Regression techniques are employed to investigate the relationship between these perceptions and both the length of tenure of pilots and their specific employer within the industry. The latter is found to have a far more significant impact on risk perception. No evidence is found for a learning curve of job risk with respect to experience. Pilots' assessments of inadequacies in training and aircraft maintenance are found to be significantly related to the financial health of their employer.

Choice of purchasing arrangements in insurance markets

Abstract: A simple dynamic model helps explain why risk-pooling purchasing arrangements evolved for health, disability, and term life insurance but not for property, automobile, or homeowners' insurance, and why whole-life policies typify life insurance purchased on an individual basis. We show that risk-pooling purchases facilitate insurance against unpredictable changes in one's risk type, but such contracts prevail in competitive equilibrium only when the loss probabilities increase with age, as they do for health, disability, and life insurance. In contrast, when the loss probability declines with age (as it does for automobile insurance), then competitive equilibrium entails separating insurance contracts.

Welfare analysis under uncertainty

Abstract: This article extends Bergsonian welfare analysis to an environment of uncertainty where preferences are not expected utility and may even be state-inconsistent. Given state-inconsistent preferences, the familiar notion of ex ante efficiency is also state-inconsistent. Other efficiency and welfare concepts achieve state consistency by ignoring entirely the prospective preferences of consumers. The framework developed in this article allows welfare judgments to be state-consistent while respecting prospective and conditional preferences. The theory is called inclusive welfare. An application to optimum insurance subsidies illustrates the practical use of the concept.