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Probability and Risk: Foundations and Economic Implications of Probability Weighting

Type of publication Peer-reviewed
Publikationsform Original article (peer-reviewed)
Publication date 2012
Author Epper Thomas, Fehr-Duda H.,
Project Vertrauen verstehen. Grundlagen, Formen und Grenzen des Vertrauens
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Original article (peer-reviewed)

Journal Annual Review of Economics
Volume (Issue) 4
Page(s) 567 - 593
Title of proceedings Annual Review of Economics
DOI 10.1146/annurev-economics-080511-110950

Open Access

Abstract

A large body of evidence has documented that risk preferences depend nonlinearly on outcome probabilities. We discuss the foundations and economic consequences of probability-dependent risk preferences and offer a practitioner's guide to understanding and modeling probability dependence. We argue that probability dependence provides a unifying framework for explaining many real-world phenomena, such as the equity premium puzzle, the long-shot bias in betting markets, and households' underdiversification and their willingness to buy small-scale insurance at exorbitant prices. Recent findings indicate that probability dependence is not just a feature of laboratory data, but is indeed manifest in financial, insurance, and betting markets. The neglect of probability dependence may prevent researchers from understanding and predicting important phenomena. “I believe, indeed, that probability nonlinearity will eventually be recognized as a more important determinant of risk attitudes than money nonlinearity.” (Prelec 2000, p. 89)
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