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The effect of the background risk in a simple chance improving decision model

Jinkwon Lee
Journal of Risk and Uncertainty
Vol. 36, No. 1 (February 2008), pp. 19-41
Published by: Springer
Stable URL: http://www.jstor.org/stable/41761328
Page Count: 23
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The effect of the background risk in a simple chance improving decision model
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Abstract

We experimentally investigate the effect of an independent and exogenous background risk to initial wealth on subjects' risk attitudes and explore an appropriate incentive mechanism when identical or similar tasks are repeated in an experiment. Taking a simple chance improving decision model under risk where the winning probabilities are negatively related to the potential gain, we find that such a background risk tends to make risk-averse subjects behave more risk aversely. Furthermore, we find that risk-averse subjects tend to show decreasing absolute risk aversion (DARA), and that a random round payoff mechanism (RRPM) would control the possible wealth effect. This suggests that RRPM would be a better incentive mechanism for an experiment where repetition of a task is used.

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