The effects of background risk on decision-making under uncertainty : an empirical investigation

Do background risks encourage, inhibit, or have no effect on risk-taking? Uninsurable background risks are an unavoidable fact of life, yet many models of decision-making fail to incorporate the potential effects of these risks on preferences and choice. Properties of “proper” or “standard” risk aversion exhibited by many common utility functions imply that background risks serve to inhibit risk-taking. I offer an opposing view. By applying the psychological concept of “diminishing sensitivity” to perceptions of risk, I argue that increased levels of background risk can serve to reduce sensitivity to a given incremental risk. Adopting a reference-based risk-return framework, I then argue that this reduced sensitivity to risk will led to diminished risk aversion and stimulate greater risk-taking behaviour. Using multiple research methods, I collect and present empirical evidence to support this thesis. Firstly, the results of two lab studies of MBA students demonstrate the thesis in a controlled experimental setting. Secondly, analysis of cross-sectional, time-series data on the in-licensing behaviour of a sample panel of pharmaceutical firms during 1988-2004 provides additional evidence of the thesis in a real-world setting. The findings contradict prevailing economic theories of background risk and have broad implications for research on decision-making, as well as practical implications for individuals, firms, and policy-makers.EThOS - Electronic Theses Online ServiceGBUnited Kingdo