A Theory of Choice Bracketing under Risk

TL;DR

This paper develops an axiomatic framework for choice heuristics like narrow bracketing and correlation neglect, explaining experimental and economic phenomena related to risk and time preferences.

Contribution

It introduces a flexible model relaxing the independence axiom, unifying models of time preferences, and providing alternatives to existing theories in macroeconomics and finance.

Findings

Explains experimental evidence of narrow bracketing.

Accounts for risk aversion over small gambles.

Unifies models of time preferences with a novel approach.

Abstract

Aggregating risks from multiple sources can be complex and demanding, and decision makers usually adopt heuristics to simplify the evaluation process. This paper axiomatizes two closed related and yet different heuristics, narrow bracketing and correlation neglect, by relaxing the independence axiom in the expected utility theory. The flexibility of our framework allows for applications in various economic problems. First, our model can explain the experimental evidence of narrow bracketing over monetary gambles. Second, when one source represents background risk, we can accommodate Rabin (2000)'s critique and explain risk aversion over small gambles. Finally, when different sources represent consumptions in different periods, we unify three seemingly distinct models of time preferences and propose a novel model that simultaneously satisfies indifference to temporal resolution of uncertainty, separation of time and risk preferences, and recursivity in the domain of lotteries. As a direct application to macroeconomics and finance, we provide an alternative to Epstein and Zin (1989) which avoids the unreasonably high timing premium discussed in Epstein, Farhi, and Strzalecki (2014).