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An Alternative to Prospect Theory

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  • Liang Zou

    (University of Amsterdam Business School)

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    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 ¨C called compound utility theory (CUT) ¨C 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.

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    Bibliographic Info

    Article provided by Society for AEF in its journal Annals of Economics and Finance.

    Volume (Year): 7 (2006)
    Issue (Month): 1 (May)
    Pages: 1-28

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    Handle: RePEc:cuf:journl:y:2006:v:7:i:1:p:1-28

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    Related research

    Keywords: Expected utility theory; Cumulative prospect theory; Compound utility theory; Reference-dependence; Nonlinear preference; Triadic preference relation; Utility-reward; Disutility-risk;

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    References

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    Cited by:
    1. Hui Huang & Shunming Zhang, 2011. "The Distorted Theory of Rank-Dependent Expected Utility," Annals of Economics and Finance, Society for AEF, Society for AEF, vol. 12(2), pages 233-263, November.

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