WP 2021-09 Structural Estimation of Higher Order Risk Preferences

AUTHOR: Morten I. Lau & Hong Il Yoo

ABSTRACT: The structural measures of higher order risk attitudes have well-developed foundations in Expected Utility Theory (EUT), but little is known about their empirical magnitudes. We propose a novel experimental design to study third and fourth order risk attitudes, known as prudence and temperance. Our design allows us to estimate a flexible non-parametric utility function, which can distinguish prudence and temperance from the usual notion of risk aversion. In an analysis that accounts for interpersonal heterogeneity and behavioral errors, we find that the EUT measures of prudence and temperance exhibit non-monotone variations over the range of monetary incentives administered. This finding defies simple characterization of higher order risk attitudes as fixed individual traits. We also consider Rank-Dependent Utility (RDU), a major generalization of EUT. We find that the EUT and RDU predictions gradually converge as the order of risk under consideration increases, and practically coincide for choices over fourth order risks.