If a person is indifferent between [x+$10] and [55% chance of x+$20, 45% chance of x], for any x, then this attitude cannot reasonably be explained by expected utility maximization. The required utility function for money would curve so sharply as to be nonsensical (for example, U($2000)-U($1000) would have to be less than U($1000)-U($950)). This result is shown in a specific case as a classroom demonstration in Section 5 of a paper of mine in the American Statistician in 1998 and, more generally, as a mathematical theorem in a paper by my old economics classmate Matthew Rabin in Econometrica in 2000.
Matt’s key assumption could be called “translation invariance”—the point is that the small-stakes risk aversion holds at a wide range of wealth levels. That’s the key assumption—the exact functional form isn’t the issue. Deb compares to a power-law utility function, but expected-utility preferences under this power law would not show substantial small-scale risk aversion across a wide range of initial wealth levels.
Right now, I’m inclined to attribute small-stakes risk aversion to some sort of rule-following. For example, it makes sense to be risk averse for large stakes, and a natural generalization is to continue that risk aversion for payoffs in the $10, $20, $30 range. Basically, a “heuristic” or a simple rule giving us the ability to answer this sort of preference question.
Attitudes, not preference or actions
By the way, I’ve used the term “attitude” above, rather than “preference.” I think “preference” is too much of a loaded word. For example, suppose I ask someone, “Do you prefer $20 or [55% chance of $30, 45% chance of $10]?” If he or she says, “I prefer the $20,” I don’t actually consider this any sort of underlying preference. It’s a response to a question. Even if it’s set up as a real choice, where they really get to pick, it’s just a preference in a particular setting. But for most of these studies, we’re really talking about attitudes.
Deb,
Thanks for the comments. Regarding Matt's paper vs. mine, it's a matter of style. The sort of argument that might convince a decision theory class might not be rigorous enough to convince an econometrician. Conversely, Matt's proof might be too abstract for the students in my class.
Regarding translation invariance, it's not really my place to say if people "should" or "shouldn't" express indifference between [x+$10] and [55% chance of x+$20, 45% chance of x]. My point (and Matt's) is that such attitudes (I wouldn't call them "preferences," for reasons discussed in my blog entry above) cannot be explained by a curving utility function.
This is not meant to dismiss power laws or other curving utility functions, just to show very dramatically that classical utility theory does not explain translation-invariant risk-aversion.
As I discuss here, I think utility analysis makes much more sense for "institutional" than for "personal" decisions, and I think it's unfortunate that decision theory textbooks tend to focus on the "personal decision" aspect.
I think people typically think about this sort of problem by rewriting: [x+$10] and [55% chance of x+$20, 45% chance of x], into a different framework. First they mentally take the $10, then think about the choice of: [55% chance of x+$10, 45% chance of x-$10] and [Do Nothing].
This rewritten problem looks like loss aversion right?
I don't see why not. Loss Aversion/Regret theories seem to be the most plausible explainations for why someone would make such a choice. Are you and/or Andrew offering a different theory? The discussion you are having is getting rather difficult to follow at this point.
Tim,
I agree that a plausible explanation for translation-invariant risk attitudes is that people "rewrite" the problem. And I agree that loss aversion is a plausible explanation for risk-aversion in the rewritten formulation.
But I would not consider loss aversion to be a reasonable explanation for the original problem of [x+$10] and [55% chance of x+$20, 45% chance of x] for positive values of x. There are simply no losses here, so I can't see loss aversion as an explanation.
"Uncertainty aversion" is a possible explanation, but, just introspecting on the problem, I don't buy it. To me, the decision to prefer x+$10 is more of an application of a general rule favoring risk-aversion, rather than a preference associated with fear of loss or uncertainty.
These distinctions could make a difference if, for example, one is considering different ways of presenting some policy options (for example, should you pay to measure your house for radon gas, or how much of a rebate should you get for switching to an insurance policy with less coverage). There is some evidence that losses are perceived differently than gains, depending on how problems are framed. One of the reasons why discussions like this can go in circles is because problems like "do you prefer the $10 or the 60% chance of $20" are too abstracted from actual decisions.
I think there may be a problem here with risk aversion being confounded with time preference. I can easily imagine refusing a gamble with 50% chance of winning $11 and 50% chance of losing $10 for a wide range of values for my total wealth. The reason is simply that if I lose the $10, I may not have enough cash to pay for lunch, and will have to take a detour to the bank, which costs me a lot more than $1 in time lost. Similarly, when people contemplate a gamble with a potential loss of $1000, they may be averse to it because they have arranged their current affairs in such a way that to absorb the loss they'd have to cash in a GIC or make some other costly adjustment in order to pay this month's rent. If you looked at gambles that will be settled in a year's time, the results might be different, since the year's lag would give plenty of time to adjust to optimally accomodate the loss. (Of course, you'd then have the cost of keeping the delayed bet in mind for a year, which is probably also greater than $1.)
Radford Neal
Radford,
You're giving a reasonable rationale for loss aversion. Concerns like yours are why I defined the problem in terms of $0,$10,$20; $10,$20,$30; $20,$30,$40; etc.–thus, all in terms of gains. It may be that people mentally subtract to place all these problems at zero, but if so, that's a problem-solving strategy they're using, not a statement about inherent preferences or utilities of $40,$50,$60, or whatever.