Time preferences and risk aversion: Tests on domain differences

J Risk Uncertain DOI 10.1007/s11166-016-9245-8 Time preferences and risk aversion: Tests on domain differences Christos A. Ioannou1 · Jana Sadeh1 © The Author(s) 2016. This article is published with open access at Springerlink.com Abstract Understanding how individuals discount and evaluate the risks of environmental outcomes is a prime component in designing effective environmental policy. We use an incentivized experimental design to investigate whether subjects’ time preferences and risk aversion across the monetary and environmental domains differ. We find that subjects’ time preferences are not significantly different across the two domains. In contrast, subjects exhibit a higher degree of risk aversion in the environmental domain. Furthermore, we corroborate earlier results, documenting that women are more risk averse than men in the monetary domain, and show this finding to also hold in the environmental domain. Keywords Risk and time · Discounting · Risk aversion · Domain differences · Environmental domain We are grateful to Michael Vlassopoulos, Manos Mentzakis, Zacharias Maniadis and Daniel Read for their comments and suggestions. We would also like to thank Stewart Barr, Andrew Darnton and the Department for Environment, Food & Rural Affairs for providing the questionnaire and guidance to the methodology. Finally, we are indebted to the Editor-in-Chief, Kip Viscusi, the Editorial Board and an anonymous referee for their detailed and helpful comments, which significantly improved the paper. The research was supported by research funds from the Economic and Social Research Council (ESRC) and the Strategic Research Development Fund (SRDF) of the University of Southampton. The usual disclaimer applies. Electronic supplementary material The online version of this article (doi:10.1007/s11166-016-9245-8) contains supplementary material, which is available to authorized users.  Christos A. Ioannou Jana Sadeh 1 Department of Economics, University of Southampton, Southampton, SO17 1BJ, UK J Risk Uncertain JEL Classification C51 · C91 · D03 · Q05 1 Introduction The design and evaluation of environmental policy requires the incorporation of time and risk elements, as many environmental outcomes extend over long time periods and involve a large degree of uncertainty. Understanding how individuals discount and evaluate risks with respect to environmental outcomes is a prime component in designing effective environmental policy to address issues of environmental sustainability, such as climate change. Our objective in this study is to investigate whether subjects’ time preferences and risk aversion across the monetary domain and the environmental domain differ. We elicit subjects’ time preferences and risk aversion using a controlled ‘withinsubject’ experimental design. First, to isolate the effect of domain on intertemporal choices, we use the fixed-sequence choice titration (Harrison and Lau 2005; Read et al. 2005; Andersen et al. 2008; Hardisty and Weber 2009). In this approach, subjects are presented with a series of binary intertemporal choices between a fixed amount that is due at one point in time (henceforth referred to as smaller sooner) and a larger amount that is due at a later point in time (henceforth referred to as larger later). While the smaller sooner amount is kept fixed, the larger later amount increases successively. In the beginning, subjects typically prefer the smaller sooner amount to the larger later one. However, at some point, a switch takes place from the smaller sooner to the larger later amount, which enables the experimenter to extract the discount-rate bracket within which the individual’s rate of time preference lies. Second, to elicit subjects’ risk aversion, we use a variant of the Eckel-Grossman test (Eckel and Grossman 2002, 2008), where subjects are presented with five gambles of varying riskiness and are required to select the one they prefer. Crucially, in order to ensure that the magnitude of the choices in the monetary domain matched those in the environmental domain, prior to running the experimental sessions, we calibrated the value of the environmental instrument using two contingent valuation studies. Finally, we use the Cognitive Reflection Test and a questionnaire to obtain a measure of subjects’ cognitive ability to reflect and deliberate in the face of intuitively simple alternatives as well as insights into subjects’ environmental attitudes, which could possibly relate to the way different domains are evaluated. A novelty of the experimental design is that it is incentivized: in the monetary domain, time preferences and risk aversion are elicited with real monetary payoffs, whereas in the environmental domain, we elicit time preferences and risk aversion using real (bee-friendly) plants.1 Our choice for the appropriate environmental instrument was not an easy one. The instrument had to be familiar to subjects to facilitate their understanding of its potential benefits, and credible so that subjects could rest assured that the project is one that can be easily implemented without arousing 1 There exists evidence to suggest that incentivized experiments may have an impact on the discount rates elicited (Coller and Williams 1999; Kirby and Maraković 1995). In fact, Andersen et al. (2014) claim “ ... the evidence is overwhelming that there can be huge and systematic hypothetical biases” (p. 27). J Risk Uncertain suspicion of deception. Finally, the instrument had to be divisible in order to enable us to vary the larger later amount and the gambles. The choice of a locally-based project that distributed bee-friendly plants fulfilled all these requirements.2 Our first set of main results does not find any significant differences in subjects’ time preferences across the monetary and environmental domains. Assuming away any philosophical or ethical issues that might dictate what the discount rate ought to be in environmental cost-benefit analysis, a corollary of the first result is that the same discount rate used for financial payoffs should also be used for the environmental ones when evaluating environmental policies. This corollary is reassuring to economists and policy makers who, for some time now, have been evaluating environmental policies with discount rates that are based on the intertemporal-choice framework of the monetary domain. Our second set of main results finds domain differences in subjects’ risk aversion. More specifically, subjects (men and women) exhibit a higher degree of risk aversion in the environmental domain relative to the monetary domain; that is, individuals tend to be more reluctant to take on large gambles with environmental outcomes than with monetary ones. A plausible explanation for the emergence of domain differences in risk aversion could be stemming from individuals’ perception on the consequences of climate change—a topic that has been well publicized. Furthermore, we corro (...truncated)