Lotto lotteries — Decision making under uncertainty when payoffs are unknown

Abstract

This paper analyses decision making under uncertainty when payoffs are unknown, similar to a Lotto lottery. In a Lotto lottery, the probability of winning a prize is known, but the size of the prize is unknown. This paper proposes a theoretical framework to model preferences over Lotto lotteries as compound lotteries. The first stage determines whether a prize is obtained, while the second stage determines the size of the prize. Then the paper empirically analyses human behaviour when uncertainty can be described as a Lotto lottery. There is considerable heterogeneity in the subjects’ aversion to lotteries with unknown payoffs. Further analysis shows that choices of decision makers can be best explained by a combination of risk and ambiguity preferences. These results suggest that subjects treat unknown payoffs similar to known payoffs with ambiguous probabilities.