An Alternative to Prospect Theory
Annals of Economics and Finance, pp. 1-27, May 2006
27 Pages Posted: 19 Mar 2010
Date Written: May 1, 2006
Abstract
This paper presents a new approach to decision-making under risk. Preference over risky prospects is defined as a triadic reference-dependent relation in a sense similar to Sugden (2003). Characterized by a set of von Neumann-Morgenstern-style axioms, a new reference-dependent representation theory - called compound utility theory (CUT) - is obtained which accommodates nonlinear preferences (in probabilities) without invoking the probability-transformation assumption of cumulative prospect theory. Given any opportunity set, a unique reference level can be identified which is consistent with CUT and which enables one to study preferences over both relative changes and absolute levels of wealth simultaneously.
Keywords: expected utility theory, cumulative prospect theory, compound utility theory, reference-dependence, nonlinear preference, triadic preference relation, utility-reward, disutility-risk
JEL Classification: D81
Suggested Citation: Suggested Citation
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