Reference Dependent Ambiguity Aversion: Theory and Experiment

Abstract

In standard models of ambiguity, the evaluation of an ambiguous asset, as of a risky asset, is considered as an independent process. In this process only information directly pertaining to the ambiguous asset is used. These models face significant challenges from the finding that ambiguity aversion is more pronounced when an ambiguous asset is evaluated alongside a risky asset than in isolation. To explain this phenomenon, we developed a theoretical model based on reference dependence in probabilities. According to this model, individuals (1) form subjective beliefs on the potential winning probability of the ambiguous asset; (2) use the winning probability of the (simultaneously presented) risky asset as a reference point to evaluate the potential winning probabilities of the ambiguous asset; (3) code potential winning probabilities of the ambiguous asset that are greater than the reference point as gains and those that are smaller than the reference point as losses; (4) weight losses in probability heavier than gains in probability. We tested the crucial assumption, reference dependence in probabilities, in an experiment and found supporting evidence.

Ambiguity Attitudes in a Large Representative Sample

“…Although we measure ambiguity attitudes relative to risky attitudes, and the two concepts are conceptually distinct (Liu, Pan, and Wang 2005 p. 149-152), they may still be statistically related (Abdellaoui et al 2011, Figures 12 and 13;Bossaerts et al 2010;Lauriola, Levin, and Hart 2007;Qiu and Weitzel 2012;our Table 8.4).…”