Stochastic expected utility theory
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This paper proposes a new decision theory of how individuals make random errors when they compute the expected utility of risky lotteries. When distorted by errors, the expected utility of a lottery never exceeds (falls below) the utility of the highest (lowest) outcome. This assumption implies that errors are likely to overvalue (undervalue) lotteries with expected utility close to the utility of the lowest (highest) outcome. Proposed theory explains many stylized empirical facts such as the fourfold pattern of risk attitudes, common consequence effect (Allais paradox), common ratio effect and violations of betweenness. Theory fits the data from ten well-known experimental studies at least as well as cumulative prospect theory.
KeywordsDecision theory Stochastic utility Expected utility theory Cumulative prospect theory
JEL ClassificationC91 D81
I am grateful to Colin Camerer, Christian Ewerhart, John Hey, Wolfgang Köhler and Andreas Ortmann as well as the participants of the research seminars in IEW (Zurich, March 31, 2005) and CERGE-EI (Prague, April 14, 2005), the 20th Biennial Conference on Subjective Probability, Utility and Decision Making (Stockholm, August 22, 2005) and the 20th Annual Congress of the European Economic Association (Amsterdam, August 25, 2005) for their extensive comments. I also would like to thank the editor W. Kip Viscusi and one anonymous referee for their helpful suggestions. Richard Gonzalez, George Wu, John Hey and Chris Orme generously provided their experimental data.
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