Time Insensitivity for Protective Investments

Investments in protective measures involve an initial immediate cost in exchange for a stream of potential benefits accruing over time in the form of reduced expected losses. This paper describes two studies in which individuals were asked both to make choices and indicate the maximum amount they were willing to pay (WTP) for such protective measures. By varying the number of years that the measures provided protection, we observed four different decision strategies that individuals use to determine their maximum WTP. The findings from these experiments strongly suggest that most individuals do not take into account the added benefits of having a protective measure in place over a longer period of time when determining the likelihood of purchasing protection or the maximum price they are willing to pay. The behavior of a relatively small proportion of the subjects was consistent with a discounted utility model. Most subjects were either myopic in their behavior or did not change their maximum WTP as the time horizon changed. Despite the fact that most subjects were insensitive to time changes, they were generally willing to purchase the protective measures. Implications of these results for investment in risk mitigation measures are briefly explored.     

Subjective Probability Weighting and the Discovered Preference Hypothesis

Numerous studies have convincingly shown that prospect theory can better describe risky choice behavior than the classical expected utility model because it makes the plausible assumption that risk aversion is driven not only by the degree of sensitivity toward outcomes, but also by the degree of sensitivity toward probabilities. This article presents the results of an experiment aimed at testing whether agents become more sensitive toward probabilities over time when they repeatedly face similar decisions, receive feedback on the consequences of their decisions, and are given ample incentives to reflect on their decisions, as predicted by Plott’s Discovered Preference Hypothesis (DPH). The results of a laboratory experiment with N = 62 participants support this hypothesis. The elicited subjective probability weighting function converges significantly toward linearity when respondents are asked to make repeated choices and are given direct feedback after each choice. Such convergence to linearity is absent in an experimental treatment where respondents are asked to make repeated choices but do not experience the resolution of risk directly after each choice, as predicted by the DPH. I thank Peter P. Wakker for useful comments and suggestions.     

Effects of Outcome and Probabilistic Ambiguity on Managerial Choices

Information ambiguity is prevalent in organizations and likely influences management decisions. This study examines, given imprecise probabilities and outcomes, how managers make choices when they are provided with single-figure benchmarks. Seventy-nine MBA students completed two experiments. We found that, in a decision framed as a decision under certainty involving an ambiguous outcome, the majority of the subjects were ambiguity prone in the loss condition and switched to ambiguity aversion in the gain condition. However, in the presence of probabilistic ambiguity in a decision under risk, this expected switching pattern was shown only when the difference in riskiness between the two choice options (in the loss condition) was perceived to be relatively small. In a companion study, we used a written protocol approach to identify factors that affect decision makers' investment choices when faced with ambiguous outcomes. Protocols frequently mentioned that the ambiguous outcome option was risky, even in the case which was framed as a decision under certainty in the problem statement. In a decision under risk with ambiguous outcomes, the combination of probabilistic risk and outcome ambiguity was seen as even more risky.     

Choosing a gambling partner: testing a model of mutual insurance in the lab

In this study, we investigate how economic agents choose gambling partners and how paired risky choices differ from individual ones. To this aim, we develop a simple model and design a laboratory experiment that allows us to compare individual versus paired decisions across two treatments, where pairs are, respectively, exogenously and endogenously formed. In both treatments, paired subjects decide individually and independently how to allocate their wealth over a portfolio of lotteries and fully commit to share any winnings. The main result from our experiment is that whenever agents are allowed to choose a gambling partner they decide to team up with other agents who display the same degree of risk aversion as themselves. Moreover, paired choices consistently involve higher risk taking than individual choices. This finding is more evident when information on subjects’ risk attitudes is made available and when subjects team up in homogeneous pairs, thereby confirming that subjects successfully exploit the benefits of mutual insurance.     

Experimental payment protocols and the Bipolar Behaviorist

If someone claims that individuals behave as if they violate the independence axiom (IA) when making decisions over simple lotteries, it is invariably on the basis of experiments and theories that must assume the IA through the use of the random lottery incentive mechanism (RLIM). We refer to someone who holds this view as a Bipolar Behaviorist, exhibiting pessimism about the axiom when it comes to characterizing how individuals directly evaluate two lotteries in a binary choice task, but optimism about the axiom when it comes to characterizing how individuals evaluate multiple lotteries that make up the incentive structure for a multiple-task experiment. We reject the hypothesis about subject behavior underlying this stance: we find that preferences estimated with a model that assumes violations of the IA are significantly affected when one elicits choices with procedures that require the independence assumption, as compared to choices elicited with procedures that do not require the assumption. The upshot is that one cannot consistently estimate popular models that relax the IA using data from experiments that assume the validity of the RLIM.     

Inferring beliefs as subjectively imprecise probabilities

We propose a method for estimating subjective beliefs, viewed as a subjective probability distribution. The key insight is to characterize beliefs as a parameter to be estimated from observed choices in a well-defined experimental task and to estimate that parameter as a random coefficient. The experimental task consists of a series of standard lottery choices in which the subject is assumed to use conventional risk attitudes to select one lottery or the other and then a series of betting choices in which the subject is presented with a range of bookies offering odds on the outcome of some event that the subject has a belief over. Knowledge of the risk attitudes of subjects conditions the inferences about subjective beliefs. Maximum simulated likelihood methods are used to estimate a structural model in which subjects employ subjective beliefs to make bets. We present evidence that some subjective probabilities are indeed best characterized as probability distributions with non-zero variance.     

Are risk preferences stable? Comparing an experimental measure with a validated survey-based measure

We examine the stability of risk preference within subjects by comparing measures obtained from two elicitation methods, an economics experiment with real monetary rewards and a survey with questions on hypothetical gambles. The survey questions have been validated by numerous empirical studies of investment, insurance demand, smoking and alcohol use, and recent studies have shown the experimental measure is associated with several real-world risky behaviors. For the majority of subjects, we find that risk preferences are not stable across elicitation methods. In interval regression models subjects’ risk preference classifications from survey questions on job-based gambles are not associated with risk preference estimates from the experiment. However, we find that risk classifications from inheritance-based gambles are significantly associated with the experimental measure. We identify some subjects for whom risk preference estimates are more strongly correlated across elicitation methods, suggesting that unobserved subject traits like comprehension or effort influence risk preference stability.     

Dynamics in risk taking with a low-probability hazard

The experiment reported in this paper identifies the effects of experience on revealed attitudes toward risk. Subjects in the experiment encountered an uncertain risk of experiencing a negative income shock over multiple periods and were able to purchase insurance at the start of each period. Subjects engaged in greater risk taking, insuring less frequently, when faced with the same risk over multiple periods. Subjects weighted experienced outcomes proportionately, in a manner consistent with rational Bayesian inference and contrary to the theory that individuals exhibit recency bias. On the other hand, subjects assigned a greater weight to outcomes that directly impacted their earnings compared to observed outcomes that had no effect on income. Unexplained autocorrelation across subjects’ choices suggests that inertia also plays an important role in repeated risk settings. I explore the relevance of these findings to public policy aimed at influencing market outcomes in the presence of infrequent environmental hazards.     

Asymmetries in Information Processing in a Decision Theory Framework

Research in psychology suggests that some individuals are more sensitive to positive than to negative information while others are more sensitive to negative rather than positive information. I take these cognitive positive–negative asymmetries in information processing to a Bayesian decision-theory model and explore its consequences in terms of decisions and payoffs. I show that in monotone decision problems economic agents with more positive-responsive information structures are always better off, ex ante, when they face problems where payoffs are relatively more sensitive to the action chosen when the state of nature is favorable.      

The Diversification Theorem Restated: Risk-pooling Without Assignment of Probabilities

Bayesian decision theory assumes that agents making choices assign subjective probabilities to outcomes, even in cases where information on probabilities is obviously absent. Here we show that agents that presume that they are equal risks can share risks mutually beneficially, even if the probabilities of losses are unpredictable or genuinely uncertain. We show also that different risk aversions among pool members do not exclude mutually beneficial loss sharing at uncertainty. Sharing when individuals’ losses differ in probabilities or in amount may still make individuals better off. Our findings are related to the theory of the insurance firm, to the management of development risks, and to the theory of justice.JEL Classification: D8, G22, L10, L30     

Competence effects for choices involving gains and losses

We investigate how choices for uncertain gain and loss prospects are affected by the decision maker’s perceived level of knowledge about the underlying domain of uncertainty. Specifically, we test whether Heath and Tversky’s (J Risk Uncertain 4:5–28, 1991) competence hypothesis extends from gains to losses. We predict that the commonly-observed preference for high knowledge over low knowledge prospects for gains reverses for losses. We employ an empirical setup in which participants make hypothetical choices between gain or loss prospects in which the outcome depends on whether a high or low knowledge event occurs. We infer decision weighting functions for high and low knowledge events from choices using a representative agent preference model. For gains, we replicate the results of Kilka and Weber (Manage Sci 47:1712–1726, 2001), finding that decision makers are more attracted to choices that they feel more knowledgeable about. However, for losses, we find limited support for our extension of the competence effect.     

Action Bias and Environmental Decisions

Individuals have a penchant for action, often for good reasons. But action bias arises if that penchant is carried over to areas where those reasons do not apply, hence is nonrational. Action bias is explored theoretically, and then empirically, using data from surveys of hypothetical environmental decisions. Quite apart from agency considerations, individuals like to affect outcomes when gains are reaped. Given the ability to help one of two sites, we find that decision makers choose to foster improvement rather than prevent deterioration, despite framing that makes it arbitrary which site is improved, which preserved. Strong action bias—individuals choosing to reap gains even though they must impose losses—is also observed. These concepts are related to loss aversion, status quo bias, omission bias for losses, and bright-line behavior.     

Measuring values: A conceptual framework for interpreting transactions with special reference to contingent valuation of visibility

People express their value for a good when they pay something for it. Interpretinggood andpayment very broadly, we offer a general analytical framework for characterizing such transactions. This framework is suitable for interpreting actual transactions as well as for creating hypothetical transactions for research purposes. It is described here both in general terms and with special application to one particular kind of transaction, contingent valuation studies in which individuals estimate the value of possible changes in atmospheric visibility. In these transactions, as in many others, risk (of undesired changes in visibility) is one principal feature; at least some uncertainty often surrounds other transaction features as well (For example: How much will visibility really change if I promise to pay for it? Will I really have to pay?). The framework presented here conceptualizes any transaction as involving (a) a good, (b) a payment, and (c) a social context within which the transaction is conducted. Each of these aspects in turn has a variety of features that might and in some cases should affect evaluations. For each such feature, the framework considers first the meaning of alternative specifications and then the difficulties of ensuring that they are understood and evaluated properly. As a whole, the framework provides an integrated approach to designing evaluation studies and interpreting their results.     

The intrinsic value of choice: The propensity to under-delegate in the face of potential gains and losses

Human beings are often faced with a pervasive problem: whether to make their own decision or to delegate the decision task to someone else. Here, we test whether people are inclined to forgo monetary rewards in order to retain agency when faced with choices that could lead to losses and gains. In a simple choice task, we show that participants choose to pay in order to control their own payoff more than they should if they were to maximize monetary rewards and minimize monetary losses. This tendency cannot be explained by participants’ overconfidence in their own ability, as their perceived ability was elicited and accounted for. Nor can the results be explained by lack of information. Rather, the results seem to reflect an intrinsic value for choice, which emerges in the domain of both gains and of losses. Moreover, our data indicate that participants are aware that they are making suboptimal choices in the normative sense, but do so anyway, presumably for psychological gains.     

Construal Processes in Preference Assessment

Interpreting people's preferences requires understanding how they have construed their tasks, interpreting the proposed alternatives in the context where the evaluation is being made. With stylized experimental or survey choices, researchers' challenge is typically identifying the features that people add in order to make their task real enough to answer (i.e., how they read between the lines). With rich “real world” choices, researchers' challenge is typically identifying the features that people neglect, as they reduce their task to manageable complexity (i.e., which lines they choose to read). In either case, if people misunderstand or mistrust the stated transaction, they may evaluate a different offer than the one that was proposed. Such misconstruals are a nuisance for investigators, insofar as dealing with them delays the measurements that motivated the research. However, they can also provide an opportunity, by focusing attention on how people give meaning to choice situations. This article describes procedures for studying construal processes, strategies for getting people to answer the questions that interest researchers, and options for interpreting responses when people construe questions differently than was intended.     

Monetary incentives in the loss domain and behavior toward risk: An experimental comparison of three reward schemes including real losses

In the loss domain, both practical and ethical considerations rule out the systematic use of an incentive-compatible procedure involving real losses. The experimental study presented here aims at investigating whether some easier-to-implement procedure could be adequately used. For that purpose, the subjects’ degree of risk aversion is compared across three payment conditions: a real-losses condition based on a random-lottery (incentive-compatible) system, which serves as a benchmark, and two challengers, namely a “losses-from-an-initial-endowment” procedure and a hypothetical-losses condition. As a by-product, our experimental design also allows us to investigate the impact of monetary incentives in the gain domain. The main result is twofold: no significant difference arises between the three payment conditions in the loss domain, while real and hypothetical choices significantly differ in the gain domain. Our results suggest that the use of monetary incentives may be more crucial in the gain domain than in the loss domain.     

Framing effects in the evaluation of multiple risk reduction

We studied how evaluation of changes in low-probability risks are affected by reference points and framing effects. Subjects considered hypothetical situations with one or two low-probability risks. Different frames were used to describe changes in risk levels. In the first experiment, subjects chose between risk-reduction options that achieved the same overall risk reduction: large reduction of one risk vs. equal (smaller) reduction of two risks. When the risks were described as losses relative to the no-risk ideal, more subjects were indifferent between the options than when the same options were described as gains relative to the status quo. In the latter case subjects preferred equal reduction of both risks, unless one risk could be reduced to zero. In a related experiment, subjects were less willing to pay any price for a commodity that carried small increases in two risks than for a commodity carrying a comparable large increase in one risk. In other experiments, subjects evaluated single changes in risks rather than comparing or evaluating pairs of changes. Subjects again placed particularly high value on reducing any risks to zero, and they were even more inclined to do so when some other risk would also be reduced to zero. In a final experiment, elimination of risk was found to be less highly valued if its source was not fully eliminated, and a status-quo effect was found. The findings are interpreted in terms of reference theories of choice.     

Framing,probability distortions,and insurance decisions

A series of studies examines whether certain biases in probability assessments and perceptions of loss, previously found in experimental studies, affect consumers' decisions about insurance. Framing manipulations lead the consumers studied here to make hypothetical insurance-purchase choices that violate basic laws of probability and value. Subjects exhibit distortions in their perception of risk and framing effects in evaluating premiums and benefits. Illustrations from insurance markets suggest that the same effects occur when consumers make actual insurance purchases.Presented at the Conference onMaking Decisions about Liability and Insurance, The Wharton School, University of Pennsylvania, Philadelphia, PA, 6–7 December, 1991. This research is supported by National Science Foundation Grant SES88-09299. The authors thank Jon Baron, Colin Camerer, Neil Doherty, Paul Kleindorfer, Amos Tversky, and two anonymous referees for many helpful comments. We particularly acknowledge the efforts of Matthew Robinson and Penny Pollister for their help with data analysis.     

The Role of Intuition in Risk/Benefit Decision-Making in Human Subjects Research

One of the key principles of ethical research involving human subjects is that the risks of research to should be acceptable in relation to expected benefits. Institutional review board (IRB) members often rely on intuition to make risk/benefit decisions concerning proposed human studies. Some have objected to using intuition to make these decisions because intuition is unreliable and biased and lacks transparency. In this article, I examine the role of intuition in IRB risk/benefit decision-making and argue that there are practical and philosophical limits to our ability to reduce our reliance on intuition in this process. The fact that IRB risk/benefit decision-making involves intuition need not imply that it is hopelessly subjective or biased, however, since there are strategies that IRBs can employ to improve their decisions, such as using empirical data to estimate the probability of potential harms and benefits, developing classification systems to guide the evaluation of harms and benefits, and engaging in moral reasoning concerning the acceptability of risks.