Compound Utility Theory: A Simple Generalized Approach to Decision Under Risk

39 Pages Posted: 10 Apr 2005

See all articles by Liang Zou

Liang Zou

University of Amsterdam - Faculty of Economics and Business (FEB)

Date Written: August 2004

Abstract

A three-dimension analytical framework for decision under risk is presented, in which preference is defined as a triadic reference-dependent relation as in Sugden (2003). Characterized by a set of von Neumann-Morgenstern-style axioms except that the independence axiom is assumed only for the valuation of utility-reward (u) and disutility-risk (d), compound utility theory (CUT) is developed that represents reference-dependent preferences in a straightforward manner. As a simple alternative to prospect theory, CUT is capable of accommodating nonlinear preferences without invoking the behavioral (nonadditive) subjective-probability or decision-weight assumptions. In applying CUT, a unique reference level can be identified given any choice context with monetary outcomes.

Keywords: Expected utility theory, prospect theory, reference-dependence, nonlinear preference, compound utility

JEL Classification: D81

Suggested Citation

Zou, Liang, Compound Utility Theory: A Simple Generalized Approach to Decision Under Risk (August 2004). Available at SSRN: https://ssrn.com/abstract=687158 or http://dx.doi.org/10.2139/ssrn.687158

Liang Zou (Contact Author)

University of Amsterdam - Faculty of Economics and Business (FEB) ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands