Risk aversion making economic decisions, certainty effect and probabilities estimation

Abstract

It has been empirically observed that the principles of utility theory are frequently violated when making decisions in risky environments. This led to the formulation of the prospect theory, in which, besides taking into account the different consideration of gains and losses (losses loom larger than gains) as well as the risk posture of decision-makers (risk aversion for gains and risk seeking for losses), the certainty effect is framed. According to such effect, decision makers tend to underestimate payments that are merely probable, compared to those that are obtained with certainty. Allais showed the irrationality that occurs in decision making in this context. On the other hand, to make risky decisions it is necessary to know how probabilities work. An experimental study was designed to determine the relationships between risk aversion, certainty effect, and basic knowledge of probability theory. In this study it was verified, using a formulation based on the Allais paradox, that those who have more knowledge of the principles of probability show greater aversion to risk. However, the fact of incurring in the certainty effect is a circumstance that is not significantly affected by such knowledge.