Scandinavian Working Papers in Economics

CERE Working Papers,
CERE - the Center for Environmental and Resource Economics

No 2018:1: Decisions under Risk Dispersion and Skewness

Oben K. Bayrak () and John D. Hey ()
Additional contact information
Oben K. Bayrak: CERE - the Center for Environmental and Resource Economics, Postal: Department of Forest Economics, University of Agricultural Sciences, 90183, Umeå, Sweden
John D. Hey: CERE - the Center for Environmental and Resource Economics, Postal: Department of Economics and Related Studies, University of York, Heslington, York, YO10 5DD, UK

Abstract: When people take decisions under risk, it is not only the expected utility that is important, but also the shape of the distribution of returns: clearly the dispersion is important, but also the skewness. For given mean and dispersion, decision‐makers treat positively and negatively skewed prospects differently. This paper presents a new behaviourally‐inspired model for decision making under risk, incorporating both dispersion and skewness. We run a horse‐race of this new model against seven other models of decision‐making under risk, and show that it outperforms many in terms of goodness of fit and, perhaps more importantly, predictive ability. It can incorporate the prominent anomalies of standard theory such as the Allais paradox, the valuation gap, and preference reversals.

Keywords: Decision under Risk; Anomalies; Valuation Gap; Preference Reversals; Allais Paradox; Skewness; Dispersion; Preference Functionals; Experiments; Pairwise Choice; Expected Utility; Non‐Expected Utility; Stochastic Specifications

JEL-codes: D81

24 pages, January 15, 2018

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