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A Stochastic Expected Utility Theory


Blavatskyy, Pavlo R (2005). A Stochastic Expected Utility Theory. Working paper series / Institute for Empirical Research in Economics No. 231, University of Zurich.

Abstract

This paper proposes a new model that explains the violations of expected utility theory throughnthe role of random errors. The paper analyzes decision making under risk when individuals makenrandom errors when they compute expected utilities. Errors are drawn from the normal distribution, which is truncated so that the stochastic utility of a lottery cannot be greater (lower) than the utility of the highest (lowest) possible outcome. The standard deviation of random errors is higher for lotteries with a wider range of possible outcomes. It converges to zero for lotteries converging to a degenerate lottery. The model explains all major stylized empirical facts such as the Allais paradox and the fourfold pattern of risk attitudes. The model fits the data from tennwell-known experimental studies at least as good as cumulative prospect theory.

Abstract

This paper proposes a new model that explains the violations of expected utility theory throughnthe role of random errors. The paper analyzes decision making under risk when individuals makenrandom errors when they compute expected utilities. Errors are drawn from the normal distribution, which is truncated so that the stochastic utility of a lottery cannot be greater (lower) than the utility of the highest (lowest) possible outcome. The standard deviation of random errors is higher for lotteries with a wider range of possible outcomes. It converges to zero for lotteries converging to a degenerate lottery. The model explains all major stylized empirical facts such as the Allais paradox and the fourfold pattern of risk attitudes. The model fits the data from tennwell-known experimental studies at least as good as cumulative prospect theory.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Economics
Working Paper Series > Institute for Empirical Research in Economics (former)
Dewey Decimal Classification:330 Economics
Language:English
Date:February 2005
Deposited On:29 Nov 2011 22:32
Last Modified:07 Dec 2017 10:10
Series Name:Working paper series / Institute for Empirical Research in Economics
ISSN:1424-0459
Official URL:http://www.econ.uzh.ch/wp.html

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