Working Paper: NBER ID: w24978
Authors: Mel Win Khaw; Ziang Li; Michael Woodford
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.
Keywords: Cognitive Bias; Risk Aversion; Decision Making
JEL Codes: C91; D03; D81; D87
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Cognitive imprecision (D80) | Risk-averse behavior (D81) |
| Mental representation of monetary amounts (E42) | Cognitive imprecision (D80) |
| Cognitive imprecision (D80) | Bias in judgment (D91) |
| Cognitive imprecision (D80) | Risk aversion does not diminish (D81) |
| Randomness in choices (D81) | Optimal decision-making under cognitive constraints (D91) |
| Cognitive imprecision (D80) | Variability in choices (D87) |
| Decision-making process (D87) | Risk-averse choices (D81) |