WP 2020-10 The Welfare Consequences of Compound Risk
AUTHORS: Glenn Harrison, Jimmy Martínez-Correa, Karlijn Morsink, Jia Min Ng, and Todd Swarthout
ABSTRACT: To avoid paternalism, behavioural welfare evaluations increasingly use information on preferences and beliefs of individuals from a “reference task,” such as a survey or experiment, to evaluate welfare gains and losses from decisions made in a context under study. This raises questions about the appropriateness of these preferences in the reference task for the decisions one aims to normatively evaluate. We propose that our beliefs about structural drivers of poor decisions, decisions that cause welfare losses, can guide the selection of an appropriate reference task for normative evaluation in many instances. We demonstrate this approach in the context of welfare evaluations of insurance choices with compound risk, where violations of the Reduction of Compound Lotteries axiom can lead to welfare losses. By using a standard risky lottery task, as well as a simple risk insurance task, we show that welfare losses do result from violations of that axiom when individuals make insurance decisions with compound risk. This is driven by excess purchase, particularly from individuals best characterized as Rank Dependent Utility decision-makers.