Exchange Economies and Loss Exposure: Experiments Exploring Prospect Theory and Competitive Equilibria in Market Environments

Abstract

A natural economic interpretation of Prospect Theory is that people have preferences that are risk seeking in losses and risk averse in gains. Thus, according to this interpretation of the theory, individuals in an exchange economy facing only losses in wealth, would have concave preferences as opposed to the usual convex preferences. That is, if individuals could engage in trade that would reduce the magnitude of expected losses and change the variance associated with losses, they would have a tendency to seek higher variance and perhaps be willing to do so at the cost of a reduction of expected value of wealth. Such individuals would be willing to sell insurance at prices below the expected value. With concave preferences all competitive equilibria have allocations at the boundaries of the Edgeworth Box. Experimental markets were constructed to determine if such behavior could be observed. The results are that risk seeking behavior is observed in many people. Furthermore, the propensity toward risk seeking in markets is consistent with answers given to questionnaires involving hypothetical choices among lotteries. The propensity toward risk seeking appears to be reduced with experience. In one sense the data are strongly supportive of Prospect Theory but in another sense the data are not. The evidence suggests that preferences in the market setting are not labile and that the risk seeking propensities are not a result of delicate framing effects. The preferences revealed in the market seemed to be a property of the people and not simply a property of their decision processes as required by Prospect Theory.