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Probability and Risk: Foundations and Economic Implications of Probability-Dependent Risk Preferences

Author

Listed:
  • Helga Fehr-Duda

    ( Institute for Environmental Decisions, ETH Zürich, 8092 Zürich, Switzerland)

  • Thomas Epper

    ( Institute for Environmental Decisions, ETH Zürich, 8092 Zürich, Switzerland
    Department of Economics, University of Zürich, 8006 Zürich, Switzerland)

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.

Suggested Citation

  • Helga Fehr-Duda & Thomas Epper, 2012. "Probability and Risk: Foundations and Economic Implications of Probability-Dependent Risk Preferences," Annual Review of Economics, Annual Reviews, vol. 4(1), pages 567-593, July.
    • Handle: RePEc:anr:reveco:v:4:y:2012:p:567-593
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    More about this item

    Keywords

    risk preferences; rank-dependent utility; cumulative prospect theory; disappointment aversion; probability weighting;
    All these keywords.

    JEL classification:

    • D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • C81 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - Methodology for Collecting, Estimating, and Organizing Microeconomic Data; Data Access
    • C90 - Mathematical and Quantitative Methods - - Design of Experiments - - - General

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