2009-11 Understanding Risk Attitudes in two Dimensions: An Experimental Analysis

Abstract

Despite extensive studies, the nature of risk attitudes remains as one of the most vigorously discussed questions in economics and psychology. In the framework of expected utility theory, attitude towards risk originates in changes in marginal utility (the curvature of the utility function). Cumulative prospect theory (CPT) adds an additional dimension: the weighting of probabilities. By examining both dimensions, we strive to gain more insights on the nature of risk attitudes: what is the relation between the curvature of utility and probability weighting? How are these related to cognitive limitations? We ran a controlled laboratory experiment to answer these questions. Our findings suggest that the two dimensions capture different characteristics of individual risk attitudes. Though, most individuals are risk averse in both dimensions, the two dimensions show no significant correlation. In addition, only probability weighting is correlated with educational background and decision time. This suggests a relation between the convexity of probability weighting and cognitive limitations.

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