Prevent or Cure? Trading in the Face of Skewed Binary Lotteries

We analyze the choice of a risk-averse decision maker who faces two lotteries that exhibit a trade-off between a reduction in the probability of a loss occurring and its magnitude. We make a theoretical analysis with skewed binary lotteries: lottery L̃ _A is associated with a lower magnitude and a higher probability of a loss occurring than lottery L̃ _B. We show that any risk-averse decision maker will prefer L̃ _A to L̃ _B when the expected gain of L̃ _A is higher than or equal to the expected gain of L̃ _B. However, in the opposite case, additional assumptions on individuals' prudence are required. We experimentally test our theoretical predictions, and provide applications and policy recommendations.