Risk and Rationality:The Relative Importance of Probability Weighting and Choice Set Dependence

We analyze the relative importance of probability weighting and choice set dependence in describing risky choices both non-parametrically and with a structural model. Our experimental design uses binary choices between lotteries that may trigger Allais Paradoxes. We change the choice set by manipulating the correlation structure of the lotteries' payoffs while keeping their marginal distributions constant. This allows us to discriminate between probability weighting and choice set dependence. There are three main results. First, probability weighting and choice set dependence both play a role in describing aggregate choices. Second, the structural model uncovers substantial individual heterogeneity which can be parsimoniously characterized by three types: 38% of subjects engage primarily in probability weighting, 34% are in uenced predominantly by choice set dependence, and 28% are mostly rational. Third, the classification of subjects into types predicts preference reversals out-of-sample. These results may not only further our understanding of choice under risk but may also prove valuable for describing the behavior of consumers, investors, and judges.