Choices under Risk in Rural Peru

Galarza, Francisco (2009): Choices under Risk in Rural Peru.

Abstract

This paper estimates the risk preferences of cotton farmers in Southern Peru, using the results from a multiple-price-list lottery game. Assuming that preferences conform to two of the leading models of decision under risk--Expected Utility Theory (EUT) and Cumulative Prospect Theory (CPT)--there is strong evidence of moderate risk aversion. Once we include individual characteristics in the estimation of risk parameters, we observe that farmers use subjective nonlinear probability weighting, a behavior consistent with CPT. Interestingly, when we allow for preference heterogeneity via the estimation of mixture models--where the proportion of subjects who behave according to EUT or to CPT is endogenously determined--we see that the majority of farmers’ choices are best explained by CPT. We further hypothesize that the multiple switching behavior observed in our sample can be explained by nonlinear probability weighting made in a context of large random calculation mistakes; the evidence found on this regard is mixed. Finally, we find that attaining higher education is the single most important individual characteristic correlated with risk preferences, a result that suggests a connection between cognitive abilities and behavior towards risk.

• Item Type: MPRA Paper
• Language: English
• Keywords: risk aversion, probability weighting, mixture models, experimental economics, Peru
• Subjects: C - Mathematical and Quantitative Methods > C9 - Design of Experiments; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty

References

Andersen, Steen, Glenn Harrison, Morten Igel Lau, and E. Elisabet Rutstrom (2006). "Elicitation using multiple price list formats," Experimental Economics, 9: 383-405.

Arrow, Kenneth (1971). Essays in the Theory of Risk-Bearing. Amsterdam: North-Holland Pub.Co.

Becker, Gordon M., Morris H. DeGroot and Jacob Marschak (1964). "Measuring Utility by a Single-Response Sequential Method," Behavioral Science, 9: 226-232.

Benjamin, Daniel, Sebastian A. Brown and Jesse M. Shapiro (2006). "Who is ‘Behavioral’? Cognitive Ability and Anomalous Preferences." Working Paper, University of Chicago.

Binswanger, Hans (1980). "Attitudes Toward Risk: Experimental Measurement in Rural India," American Journal of Agricultural Economics, 62(3): 395-407.

Binswanger, Hans (1981). "Attitudes Toward Risk: Theoretical Implications of an Experiment in Rural India," Economic Journal, 91(364): 867-890.

Binswanger, Hans, Dayanatha Jha, T. Balaramaiah and Donald Sillers (1980). "The impacts of risk aversion on agricultural decisions in semi-arid India," International Crops Research Institute for the Semi-Arid Tropics, Hyderabad, India. Mimeo.

Bruhin, Adrian, Helga Fehr-Duda and Thomas F. Epper (2007). "Risk and Rationality: Uncovering Heterogeneity in Probability Distortion," SOI Working Paper 0705, Socioeconomic Institute, University of Zurich, July.

Bruner, David (2007). "Multiple Switching Behavior in Multiple Price Lists," Mimeo, University of Calgary, Department of Economics.

Bruner, David, Michael McKee and Rudy Santore (2008). "Hand in the Cookie Jar: An Experimental Investigation of Equity-based Compensation and Managerial Fraud," Southern Economic Journal, 75(1): 261-78.

Burks, Stephen, Jerey Carpenter, Lorenz Goette and Aldo Rusticini (2009). "Cognitive Skills Explain Economic Preferences, Strategic Behavior and Job Attachment," Working Paper.

Camerer, Colin and Teck-Hua Ho (1994). "Violations of the betweenness axiom and nonlinearity in probability," Journal of Risk and Uncertainty, 8(2): 167-196.

Cardenas, Juan Camilo and Jerey Carpenter (2008). "Behavioural Development Economics: Lessons from Field Labs in the Developing world," Journal of Development Studies, 44 (3): 337-364.

Conte, Anna, Peter Moat and John Hey (2008). "Mixture models of choice under risk", Journal of Econometrics, forthcoming.

Cox, James C. and Glenn Harrison (eds.) (2008). Risk Aversion in Experiments. Bingley, U: Emerald, Research in Experimental Economics, Volume 12.

Dohmen, Thomas, Armin Falk, David Human and Uwe Sunde (2007). "Are Risk Aversion and Impatience Related to Cognitive Ability?," IZA Discussion Paper No. 2735. Bonn, Germany: Institute for the Study of Labor (IZA).

Eckel, Catherine and Philip Grossman (2008). "Forecasting Risk Attitudes: An Experimental Study Using Actual and Forecast Gamble Choices," Journal of Economic Behavior and Organization, 68(1): 1-17.

Eckel, Catherine and Rick Wilson (2004). "Is Trust a Risky Decision?," Journal of Economic Behavior and Organization, 55(4): 447-465.

Engle-Warnick, Jim, Javier Escobal and Sonia Laszlo (2007). "Ambiguity Aversion as a Predictor of Technology Choice: Experimental Evidence from Peru," Scientific Series 2007s-01. Montreal, CIRANO.

Fechner, Gustav T. (1860/1966). Elements of Psychophysics. New York: Holt Rinehart and Winston.

Feder, Gershon (1980). "Farm Size, Risk Aversion and the Adoption of New Technology under Uncertainty," Oxford Economic Papers, 32(2): 263-283.

Feder, Gershon, Richard Just and David Zilberman (1985). "Adoption of Agricultural Innovations in Developing Countries: A Survey," Economic Development and Cultural Change, 33: 255-297

Fehr-Duda, Helga, Manuele de Gennaro and Renate Schubert (2006a). "Gender, Financial Risk, and Probability Weights," Theory and Decision, 60: 283-313.

Fehr-Duda, Helga, Marc Sch�urer and Renate Schubert (2006b). "What Determines the Shape of the Probability Weighting Function," Economics Working Papers 06/54, Center for Economic Research at ETH Zurich.

Fox, Craig R. and Russel A. Poldrack (2009). "Prospect Theory and the Brain," In: Glimcher, Paul W., Colin F. Camerer, Ernst Fehr and Russell A. Poldrack (eds.), Neuroeconomics. Decision Making and the Brain (pp.145-173). London; San Diego, CA: Academic Press.

Frederick, Shane (2005). "Cognitive Reflection and Decision Making," Journal of Economic Perspectives, 19(4): 25-42.

Galarza, Francisco (2009). "Risk, Credit, and Insurance in Peru: Field Experimental Evidence," Working Paper, Department of Agricultural and Applied Economics, University of Wisconsin-Madison.

Gonzalez, Richard and George Wu (1999). "On the Shape of the Probability Weighting Function," Cognitive Psychology, 38: 129-166.

Guiso, Luigi and Monica Paiella (2007). "Risk Aversion, Wealth, and Background Risk," EUI Working Paper No. 47, Department of Economics, European University Institute (EUI), Italy.

Harrison, Glenn (2007). "Maximum Likelihood Estimation of Utility Functions Using Stata," Working Paper # 06-12, Department of Economics, College of Business Administration, University of Central Florida, April.

Harrison, Glenn, Morten I. Lau and Elisabet Rutstrom (2007). “Estimating Risk Attitudes in Denmark: A Field Experiment," Scandinavian Journal of Economics, 109(2): 341-368.

Harrison, Glenn and John List (2004). “Field Experiments," Journal of Economic Literature, 42 (4): 1013-1059.

Harrison, Glenn and Elisabeth Rutstrom (2008). “Risk Aversion in the Laboratory." In: Cox, James and Glenn Harrison (eds.), Risk Aversion in Experiments. Bingley, U: Emerald, Research in Experimental Economics, Volume 12, pp. 41-196).

Harrison, Glenn and Elisabeth Rutstrom (2009). “Expected Utility Theory and Prospect Theory: One Wedding and A Decent Funeral," Experimental Economics, 12. Forthcoming.

Harrison, Glenn, Morten Lau, Elisabeth Rutstrom and Melanie Williams (2005). “Eliciting Risk and Time Preferences Using Field Experiments: Some Methodological Issues," in: Carpenter, Jeffrey, Glenn Harrison and John List (eds.), Field Experiments in Economics. Greenwich, CT: JAI Press, Research in Experimental Economics, Volume 10.

Harrison, Glenn, Eric Johnson, Melayne McInnes and Elisabet Rutstrom (2005). “Risk Aversion and Incentive Effects: Comment," American Economic Review, 95(3): 900-904.

Harrison, Glenn, Steven J. Humphrey and Arjan Verschoor (2009). “Choice Under Uncertainty: Evidence from Ethiopia, India and Uganda," The Economic Journal, 119, Forthcoming.

Henrich, Joseph and Richard McElreath (2002). “Are Peasants Risk-Averse Decision Makers?," Current Anthropology, 43(1): 172{181.

Hey, John, Andrea Morone and Ulrich Schmidt (2007). “Noise and Bias in Elicitating Preferences," Discussion Paper in Economics No. 2007/04, Department of Economics and Related Studies, University of York, UK.

Hey, John D. and Chris Orme (1994). “Investigating Generalizations of Expected Utility Theory Using Experimental Data," Econometrica, 62(6): 1291-1326.

Holt, Charles and Susan Laury (2002). “Risk Aversion and Incentive Effects," American Economic Review, 92(5): 1644-1655.

Holt, Charles and Susan Laury (2005). “Risk Aversion and Incentive effects: New Data without Order Effects," American Economic Review, 95(3): 902-904.

Jacobson, Sarah and Ragan Petrie (2009). “Learning from Mistakes: What Do Inconsistent Choices Over Risk Tell Us?," Journal of Risk and Uncertainty, 38(2): 143-158. Kahneman, Daniel and Amos Tversky (1979). “Prospect Theory: An Analysis of Decision Under Risk," Econometrica, 47(2): 263-292.

Kachelmeir, Steven J. and Mohamed Shehata (1992). “Examining Risk Preferences Under High Monetary Incentives: Experimental Evidence from the People’s Republic of China," American Economic Review, 82(5): 1120-1141.

Lattimore, Pamela K., Joanna R. Baker and Ann D. Witte (1992). “The Influence of Probability on Risky Choice," Journal of Economic Behavior and Organization, 17: 377-400.

Liu, Elaine (2008). “Time to Change What to Sow: Risk Preferences and Technology Adoption Decisions of Cotton Farmers in China," Job Market Paper, Princeton University, Department of Economics.

List, John (2004). “Neoclassical Theory versus Prospect Theory: Evidence from the Marketplace," Econometrica, 72(2): 615-625.

Loomes, Graham, Peter G. Moffat and Robert Sugden (2002). “A Microeconometric Test of Alternative Stochastic Theories of Risky Choice," Journal of Risk and Uncertainty, 24(2): 103-130.

Luce, R. Duncan (1959). Individual Choice Behavior; A Theoretical Analysis. New York: Wiley.

Luce, R. Duncan (2000). Utility of Gains and Losses: Measurement{Theoretical and Experimental Approaches. Mahwah, N.J.; London: Lawurence Erlbaum Associates (Scientific Psychology Series).

Maddala, G.S. (1983). Limited-dependent and qualitative variables in econometrics. Cambridge, New York: Cambridge University Press.

McLachlan, Geoffrey and David Peel (2000). Finite Mixture Models, New York: Wiley.

Prelec, Drazen (1998). “The Probability Weighting Function," Econometrica, 66: 497-527.

Quiggin, John (1982). “A Theory of Anticipated Utility," Journal of Economic Behavior and Organization, 3(4): 323-343.

Rieger, Marc Oliver and Mei Wang (2006). “Cumulative Prospect Theory and the St. Petersburg Paradox," Economic Theory, 28: 665-679.

Schechter, Laura (2007). “Risk Aversion and Expected Utility Theory: A Calibration Exercise," Journal of Risk and Uncertainty, 35(1): 67-76.

Starmer, Chris (2000). “Developments in Non-Expected Utility Theory: The Hunt for a Descriptive Theory of Choice Under Risk," Journal of Economic Literature, 38: 332-382.

Tanaka, Tomomi, Colin Camerer and Quang Nguyen (2009): “Risk and Time Preferences: Linking Experimental and Household Survey Data from Vietnam," American Economic Review, forthcoming.

Train, Kenneth (2003). Discrete Choice Methods with Simulation. Cambridge University Press.

Tversky, Amos and Daniel Kahneman (1992). “Advances in Prospect Theory: Cumulative Representations of Uncertainty," Journal of Risk and Uncertainty, 5(4): 297-323.

Wilcox, Nathaniel (2008). “Stochastic Models for Binary Discrete Choice Under Risk: A Critical Primer and Econometric Comparison," In: Cox, James and Glenn Harrison (eds.), Risk Aversion in Experiments. Bingley, U: Emerald, Research in Experimental Economics, Volume 12 (pp. 197-292).

Wu, George and Richard Gonzalez (1996). “Curvature of the probability weighting function," Management Science, 42: 1676-1690.