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Using Prospect Theory to Analyze New Risks (Ambiguity) in a Large Representative Sample and to Explain Real Investment Decisions

Wednesday 23 January 2013, 1.15PM to 2.45pm

Speaker(s): Peter Wakker, Erasmus University Rotterdam

Abstract: Since Keynes (1921) & Knight (1921) we know that uncertainties in economics usually do not come with objective statistical probabilities. De Finetti (1931) and Savage (1954) proposed to still use probabilities in such cases, which then have to be subjective. However, Ellsberg (1961) showed that in most cases no subjective probabilities can be assigned in any traditional sense (ambiguity). Hence we need fundamentally new models. Only at the end of the 1980s, Gilboa & Schmeidler succeeded in introducing such models. The first ones were all theoretical and normatively motivated, assuming expected utility for known probabilities and focusing on ambiguity aversion. Tversky & Kahneman (1992) incorporated the Gilboa-Schmeidler ideas into prospect theory, leading to the first empirically realistic model of ambiguity. We introduce the source model, a special tractable version of prospect theory. It yields exact predictions and ambiguity premiums, and easy graphs to fully capture ambiguity attitudes. We can now let the data speak on ambiguity, showing a rich set of phenomena beyond the mere ambiguity aversion assumed in the normatively oriented theoretical models such as multiple priors, a-maxmin, and smooth utility.

We first implement the source method in a laboratory experiment, and then in an incentivized survey over N=1,935 households, where we investigate the impact of ambiguity on household portfolio choices. In particular, we can now analyze the influence of ambiguity on the nonparticipation paradox of households that invest less in stocks than any normative theory can explain.

Paper: Using Prospect Theory to Analyze New Risks (PDF , 606kb)

Location: ARRC Auditorium (A/RC/014)

Admission: Economics Department Seminar. All welcome to attend