Quotation Walther, Herbert. 2008. S-shaped probability weighting and hyperbolic discounting - an intimate relationship.


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Abstract

Intertemporal decision-making has to account for the inevitable uncertainty surrounding the realization of delayed gains and losses. As this paper demonstrates, time-dependent uncertainty implies that S-shaped probability weighting and hyperbolic discounting will be positively correlated traits. Both phenomena are explained within state-dependent expected utility theory by considering elation and disappointment in addition to the wealth effects associated with the realization of (delayed) gains and losses. Various other `anomalies` are analyzed within the same framework. It is shown that constant relative risk aversion is sufficient to generate (1) a `sign effect' (losses are discounted less than gains), (2) a `delay/speed-up' asymmetry (delays are discounted at higher rates) and (3) a `magnitude effect' for losses (larger outcomes are discounted less). However, a `reverse' magnitude effect develops for gains (larger outcomes are discounted more). The `magnitude effect' for gains observed in experimental settings is rationalized by incorporating transaction costs within the domain of `small' gains. (4) As a corollary, a wealth effect is identified, implying that the poor subject will be less patient with regard to gains and losses. Keywords: Hyperbolic time preferences, Decision-Making under Uncertainty, Probability Weighting JEL classification: D11, D81, D91

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Publication's profile

Status of publication Published
Affiliation WU
Type of publication Working/discussion paper, preprint
Language English
Title S-shaped probability weighting and hyperbolic discounting - an intimate relationship
Year 2008

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People
Walther, Herbert (Details)
Organization
Department of Economics (Kartal) (Details)
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