Probability Premium and Attitude Towards Probability

Abstract

Employing a generalized definition of Pratt (1964) and Arrow's (1965, 1971) probability premium, we introduce a new concept of attitude towards probability. We illustrate in a problem of risk sharing that whether attitude towards probability is a first-order or second-order phenomenon has important economic applications. By developing a local approximation to the probability premium, we show that the canonical rank-dependent utility model usually exhibits attitude towards probability of first order, whereas under the dual theory with smooth probability weighting functions attitude towards probability is a second-order trait.