Risk Aversion and Incentive Effects: Comment

Abstract

Charles A. Holt and Susan K. Laury (2002) develop an experimental design to determine the risk attitude of an individual. They use their observations to argue that increased incentives appear to change risk attitudes, leading to greater risk aversion. Popular utility functions that do not allow for such effects are therefore misspecified. Building on this finding, they estimate a flexible utility function that characterizes their aggregate data well, but that does not assume constant (absolute or relative) risk aversion. The basic Holt and Laury (2002) (HL) design should become an important tool for the interpretation and design of experiments in which risk attitudes could play a role. However, their most important result—showing the effect of scaling up the stakes of the lottery choice task—is confounded by a possible order effect. An order effect occurs when prior experience with one task affects behavior in a subsequent task. The primary methodological contribution of experiments in economics is to enhance control. Ideally, such control makes the explanatory variables of interest, in this case scale, orthogonal to other explanatory variables such as order, allowing clearer inferences about behavior than one could get from field econometric data. We argue that not controlling for order effects results in a misspecification of utility functions that is as important as that of scale. The subjects in the HL design were given sequences of three or four tasks, as shown in Table 1. Task #1 involved choices over lotteries with a baseline level of prizes, which we will refer to as the “1 scale.” Task #2 involved hypothetical choices over prizes with a scaled-up level of prizes, either 20 , 50 , or 90 . Task #3 repeated task #2, but with choices that involved real payoffs. Task #4 was a return to the baseline task with real 1 prizes. In some sessions, subjects were not given task #2 or task #3. What could one infer from the comparison of measured risk attitudes in the 1 and 20 tasks in HL? Unfortunately, any observed difference could be due either to the scale of the prizes involved or the task order, or some combination of both. Thus, the effect of scale is intrinsically confounded with the possible effect of task order. This is a logical flaw in their design, which

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@inproceedings{HARRISON2005RiskAA, title={Risk Aversion and Incentive Effects: Comment}, author={GLENN W. HARRISON and ERIC JOHNSON and MELAYNE M. MCINNES and ELISABET RUTSTR{\"{O}M and Charles A. Holt and Susan K. Laury}, year={2005} }