Preferences with Adaptive Risk Assessments

Abstract

We model a decision maker who can exert costly effort to adapt her risk assessments, thereby optimizing the value of her risky prospects. We provide an axiomatic characterization of the model, and show how costs of adaption can be elicited and compared across individuals. In a moral hazard problem we show that adaption of risk assessments can weaken the effect of monetary incentives for effort provision, which have important implications for agency problems. We also provide several examples to illustrate how adaption of risk assessments can rationalize many well-known choice anomalies (e.g., the common consequence, certainty, or magnitude effects). These behavioral implications follow from a key feature of the model that adaption decisions can respond to changes in incentives.