Working Paper: NBER ID: w31573
Authors: Cary Frydman; Lawrence J. Jin
Abstract: We propose and experimentally test a new theory of probability distortions in risky choice. The theory is based on a core principle from neuroscience called efficient coding, which states that information is encoded more accurately for those stimuli that the agent expects to encounter more frequently. As the agent's prior beliefs vary, the model predicts that probability distortions change systematically. We provide novel experimental evidence consistent with the prediction: lottery valuations are more sensitive to probabilities that occur more frequently under the subject's prior beliefs. Our theory generates additional novel predictions regarding heterogeneity and time variation in probability distortions.
Keywords: No keywords provided
JEL Codes: D03; G02; G41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| prior beliefs (D80) | valuation of lotteries (H27) |
| prior beliefs concentrated near intermediate values (D80) | sensitivity of valuation to changes in probability (D81) |
| prior beliefs focused on extreme probabilities (D80) | sensitivity of valuation to changes in probability (D81) |