RISK PREFERENCES AND EXPECTED UTILITY: EVIDENCE FROM LABOR SUPPLY DATA

This paper adds to the growing body of evidence that observed risk preferences are not consistent with expected‐utility theory. Using the link between labor supply decisions and utility as outlined by Chetty (“A Bound on Risk Aversion Using Labor Supply Elasticities.” The American Economic Review, 96(5), 2006, 1821–34), I compute the curvature of utility over wealth for 3,900 individuals in the 1996 Panel Study of Income Dynamics. I then compare this estimate to a measure of relative risk aversion based on the respondents' answers to hypothetical gambling questions and find virtually zero correlation. Finally, I investigate how the two measures and their correlations change by demographic groups and risky behavior. (JEL C81, D80, J22)     

Gambling versus investment: Lay theory and loss aversion

Gambling and investment are two domains that involve financial decisions. The present research investigates people’s lay theories about gambling and investment, and how these lay theories affect loss aversion in these domains. Lay people’s understanding of gambling and investment is often largely based on information that is immediately available to them. Moreover, information about losing money by gambling and earning money through investments are more predominant than information about earning money by gambling and losing money through investments. Hence, we hypothesized and found that people tend to hold lay theories that gambling is more likely to cause losses and less likely to bring gains compared to investment (Study 1); and we observed a stronger loss aversion when the same monetary decision was framed as gambling rather than as an investment (Studies 2 to 6). This domain-framing effect held in both hypothetical and incentivized settings.     

RISK TAKING FOR ONESELF AND OTHERS: A STRUCTURAL MODEL APPROACH

Economic theory makes no predictions about social factors affecting decisions under risk. We examine situations in which a decision maker decides for herself and another person under conditions of payoff equality, and compare them to individual decisions. By estimating a structural model, we find that responsibility leaves utility curvature unaffected, but accentuates the subjective distortion of very small and very large probabilities for both gains and losses. We also find that responsibility reduces loss aversion, but that these results only obtain under some specific definitions of the latter. These results serve to generalize and reconcile some of the still largely contradictory findings in the literature. They also have implications for financial agency, which we discuss.     

Perceived risk and the precautionary demand for money

Keynes contended that individuals hold money for fear of being unable to meet unforeseen future cash requirements. This ‘precautionary demand’ for money has long been an accepted part of monetary theory, but has played a subservient role because of our inability to measure an individual's degree of aversion to risk. This study, however, employs a risk taking scale, similar to that developed by Zuckerman, to empirically investigate Keynes's precautionary demand for money. The results are sufficiently encouraging to suggest that this scale might successfully be applied to other economics subfields in which risk plays a role.     

Interpersonal risk assessment and social preferences: An experimental study

We investigate interpersonal risk assessment, that is how individuals use either their own or their partner’s monetary resources to offset the risk that affects them or their partner. The observed behavior is in line with the predictions of a simple piecewise linear model of social preferences. Overall, individuals opportunistically draw from others’ resources to offset risk; furthermore, they display higher levels of risk aversion when delegated to choose for others rather than when choosing for themselves. However, different social types differ in the assessment of interpersonal risk. Considering our results, we suggest that studies dealing with interpersonal risk assessment should not only focus on risk preferences, but also take into account social preferences.     

RISK PREFERENCE ESTIMATION IN THE NONLINEAR MEAN STANDARD DEVIATION APPROACH

Risk preferences and technology are jointly estimated in the nonlinear mean-standard deviation framework for a competitive firm model under price risk. A utility function is proposed that nests various risk preference structures and risk neutrality as empirically refutable special cases. The empirical application using firm-level data finds evidence of decreasing absolute risk aversion, differences in the nature of relative risk aversion by firm size, and little support for the widely used linear mean-variance framework. The estimation results also show that ignoring risk and risk preferences can substantially overestimate output supply and input demand elasticities.     

Aggregation of individuals' preference intensities into social preference intensity

A result of John Harsanyi concerns the aggregation of individuals' preferences into social preferences. The result states that if the individuals in a society and the society as a whole have preference relations that compare probability distributions on a set of outcomes, and the preference relations satisfy expected-utility conditions and Pareto conditions, then a utility function for the social preference relation is a positive affine function of utility functions for the individuals' preference relations. This paper presents an analogous result for preference relations that denote intensity of preference, i.e., preference relations that compare exchanges of outcomes. This approach avoids the difficulties of requiring that the individuals in the society have common beliefs regarding uncertainty. Received: 14 October 1996 / Accepted: 4 September 1997     

Stochastic Dominance and Absolute Risk Aversion

In this paper, we propose the infimum of the Arrow–Pratt index of absolute risk aversion as a measure of global risk aversion of a utility function. We show that, for any given arbitrary pair of distributions, there exists a threshold level of global risk aversion such that all increasing concave utility functions with at least as much global risk aversion would rank the two distributions in the same way. Furthermore, this threshold level is sharp in the sense that, for any lower level of global risk aversion, we can find two utility functions in this class yielding opposite preference relations for the two distributions.This paper has benefited from insightful comments made by James Mirrless, two anonymous referees, and by seminar participants at IAE and Simposio de Análisis Económico in Salamanca. They should not bear any responsibility for the remaining errors. Financial support from the Spanish Ministry of Education and Science and FEDER through grants SEC2003-306 and SEC2003-1961, from the Generalitat of Catalonia through the Barcelona Economics program (CREA) and grants 2005SGR00447 and 2005SGR00626 is gratefully acknowledged. This paper is part of the “Polarization and Conflict” project, contract 3CIT2-CT-2004-506084 funded by the European Commission.     

Are Risk Attitudes Fixed Factors or Fleeting Feelings?

We investigate the stability of measured risk attitudes over time, using a 13-year longitudinal sample of individuals in the National Longitudinal Survey of Youth 1979. We find that an individual’s risk aversion changes systematically in response to personal economic circumstances. Risk aversion increases with lengthening spells of employment and time out of labor force, and decreases with lengthening unemployment spells. However, the most important result is that the majority of the variation in risk aversion is due to changes in measured individual tastes over time and not to variation across individuals. These findings that measured risk preferences are endogenous and subject to substantial measurement errors suggest caution in interpreting coefficients in models relying on contemporaneous, one-time measures of risk preferences.     

Time Preference and Life Cycle Consumption with Endogenous Survival

We provide a structural theory of time preference and derive a functional form of intertemporal preferences by postulating that individuals make their life-cycle consumption choices as if to maximize expected lifetime. This yields a nontime-separable expected utility representation where the inverse of the coefficient of intertemporal substitution exceeds the coefficient of relative risk aversion. The rate of time preference depends on the inverse of expected remaining lifetime and the effect of age on the productivity of consumption in affecting health. The preference formulation is applied in a standard intertemporal consumption model to illustrate the implied life-cycle consumption choices ( JEL D91, B41).     

Risk attitudes and risky behavior

In economic theory, risk aversion is a characteristic of the typical utility function of money. Observations of how people deal with risks in real life have cast some doubts on the prevalence of risk aversion. People buy insurance, but they also gamble and take investment risks. Many of the conclusions in the discussions of utility derive from experiments employing some kind of lottery choices. While the experiments have given interesting ideas for theory, there has been little testing of the extent to which the obtained measures of risk attitudes correlate with actual behavior. Data from the VSB panel were used to answer three questions: (1) Can hypothetical risky choice questions be meaningfully answered by ordinary survey respondents? (2) What are the relationships between different measures of risk attitudes and actual portfolio choices of risky assets? (3) What is the relationship between risk attitude and playing in lotteries, lotto, etc.?     

The arithmetic of outcome editing in financial and social domains

Outcome editing refers to a set of mental rules that people apply when deciding whether to evaluate multiple outcomes jointly or separately, which subsequently affects choice. In a large-scale online survey (n = 2062) we investigate whether individuals use the same outcome editing rules for financial outcomes (e.g., a lottery win) and social outcomes (e.g., a party with friends). We also test the role of numeric ability in explaining outcome editing. Our results show that people’s preferences for combining or separating events depend on whether those events are in the financial or the social domain. Specifically, individuals were more likely to segregate social outcomes than monetary outcomes, except for when all outcomes were negative. Moreover, numeric ability was associated with preferences for outcome editing in the financial domain but not in the social domain. Our findings extend the understanding of the arithmetic operations underlying outcome editing and suggest that people rely more on calculations when making choices involving multiple financial outcomes and more on feelings when making choices involving social outcomes.     

Sex hormones and choice under risk

We study the correlation of choice under risk in Holt–Laury lotteries for gains and losses with gender, the use of hormonal contraceptives, menstrual cycle information, salivary testosterone, estradiol, progesterone, and cortisol as well as the digit ratio (2D:4D; length of the index finger to the ring finger of the right hand) in more than 200 subjects (45% females). In males, salivary testosterone is negatively correlated with risk aversion for gains only. In females, salivary cortisol is positively correlated with risk aversion for gains only. No other significant correlations between risk preferences and salivary hormones are observed. No significant correlations between risk preferences and the menstrual cycle are observed in naturally cycling females. No significant correlations between risk preferences and the digit ratio are observed in either gender and/or race.     

THE NEAR OPTIMALITY OF MARK-UP PRICING

Mark-up pricing policies result in a loss of profits compared to marginal pricing behavior. These losses, however, are often very small, even for large changes in the money supply. But by adopting a simple pricing rule the firm does not have to forecast the future, and avoids the informational and computational costs required to determine the profit maximizing price each period. Thus, even if these costs are small, mark-up pricing policies may be optimal, or approximately so, at least for some firms. In a macro model this is likely to imply large monetary non-neutralities.     

Does patience matter in marriage stability? Some evidence from Italy

Time preferences can affect divorce probability by both affecting the quality of the match and affecting the spouses’ reactions to negative shocks. We analyse the relationship between time preferences and divorce decisions using data from the Italian Survey on Household Income and Wealth, which provides a measure of time preferences based on a hypothetical financial situation in which individuals have to decide how much money to give up in order to receive a certain amount of money immediately rather than in one year’s time. By controlling for a number of individual and family characteristics, we find that impatient individuals are more likely to experience divorce. The effect is robust to different specifications of our model and is not affected by reverse causality problems. We also find that the more risk averse individuals are, the less likely they are to experience divorce.     

How does inequality aversion affect inequality and redistribution?

We investigate the effects of inequality aversion on equilibrium labor supply, tax revenue, income inequality, and median voter outcomes in a society where agents have heterogeneous skill levels. These outcomes are compared to those which result from the behavior of selfish agents. A variant of Fehr-Schmidt preferences is employed that allows the externality from agents who are “ahead” to differ in magnitude from the externality from those who are “behind” in the income distribution. We find first, that inequality-averse preferences yield distributional outcomes that are analogous to tax-transfer schemes with selfish agents, and may either increase or decrease average consumption. Second, in a society of inequality-averse agents, a linear income tax can be welfare-enhancing. Third, inequality-averse preferences can lead to less redistribution at any given tax, with low-wage agents receiving smaller net subsidies and/or high-wage individuals paying less in net taxes. Finally, an inequality-averse median voter may prefer higher redistribution even if it means less utility from own consumption and leisure.     

The Frustrating Effects of Just Missing the Jackpot: Slot Machine Near-Misses Trigger Large Skin Conductance Responses, But No Post-reinforcement Pauses

Near-misses in slot machines resemble jackpot wins but fall just short. Previous research has demonstrated that near-misses are behaviorally reinforcing despite the absence of monetary reward. We assessed the hedonic properties of near-misses by measuring the time between outcome delivery and the initiation of the next spin—the post-reinforcement pause (PRP) and skin conductance responses (SCRs) for losses, near-misses, and a range of wins (5, 15, 25, 50 or 250 credits) while participants (N = 122) played a slot machine simulator. PRPs and SCRs were compared for 40 low frequency and 22 high frequency slots players who were non-problem gamblers, 37 at risk players, and 23 problem gamblers. For winning outcomes, PRPs and SCRs tracked monotonically with win size such that progressively larger wins were associated with progressively larger PRPs and SCRs. Near-misses with jackpot symbols landing on the first two reels had significantly larger SCRs than regular losses, and other types of near misses. Crucially, PRPs for this kind of near-miss were significantly smaller than all wins, and when non-parametric statistics were used, significantly smaller than regular losses. This pattern of large SCRs and small PRPs suggest that these are highly frustrating outcomes that stimulate appetitive components of the reward system to promote continued gambling.     

An evolutionary explanation for risk aversion

Recent models of the evolution of preferences have provided profound new insights into the origins of risk attitudes. In most of these models the evolutionary “objective function” is the maximization of the expected number of offspring, or alternatively, the maximization of the geometric-mean growth rate. We suggest that careful consideration should also be given to the objective of maximizing the probability of Having Descendants Forever, p(HDF). We show that the p(HDF) criterion implies risk aversion. Moreover, it leads to preferences that are very closely approximated by the constant relative risk aversion preferences. Thus, constant relative risk aversion can be viewed as an evolutionary-developed heuristic aimed to maximize the probability of having descendants forever.     

Characterizing uncertainty aversion through preference for mixtures

Uncertainty aversion is often modelled as (strict) quasi-concavity of preferences over uncertain acts. A theory of uncertainty aversion may be characterized by the pairs of acts for which strict preference for a mixture between them is permitted. This paper provides such a characterization for two leading representations of uncertainty averse preferences; those of Schmeidler [24] (Choquet expected utility or CEU) and of Gilboa and Schmeidler [16] (maxmin expected utility with a non-unique prior or MMEU). This characterization clarifies the relation between the two theories. Received: 20 February 1998/Accepted: 25 March 1999