A Theory of Choice Bracketing under Risk

Abstract: Aggregating risks from multiple sources can be complex and demanding, and decision makers usually adopt heuristics to simplify the evaluation process. This paper axiomatizes two closed related and yet different heuristics, narrow bracketing and correlation neglect, by relaxing the independence axiom in the expected utility theory. The flexibility of our framework allows for applications in various economic problems. First, our model can explain the experimental evidence of narrow bracketing over monetary gambles. Second, when one source represents background risk, we can accommodate Rabin (2000)'s critique and explain risk aversion over small gambles. Finally, when different sources represent consumptions in different periods, we unify three seemingly distinct models of time preferences and propose a novel model that simultaneously satisfies indifference to temporal resolution of uncertainty, separation of time and risk preferences, and recursivity in the domain of lotteries. As a direct application to macroeconomics and finance, we provide an alternative to Epstein and Zin (1989) which avoids the unreasonably high timing premium discussed in Epstein, Farhi, and Strzalecki (2014).