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Comparison of Mean-Variance Theory and Expected-Utility Theory through a Laboratory Experiment

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  • Andrea Morone

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Abstract

In the 40's and early 50' two decision theories were proposed and have since dominated the scene of the fascinating field of decision-making. In 1944 - when von Neumann and Morgenstern showed that if preferences are consistent with a set of axioms then it is possible to represent these preferences by the expectation of some utility function - Expected Utility theory provides a natural way to establish "measurable utility". In the early 50's Markowitz introduced the Mean-Variance theory that is the basis of modern portfolio selection theory. Even if both models were analyzed from virtually all possible points of view; although they were tested against several generalizations; even though they seem to be the most attractive theories of decision making, they were never tested against each other. This paper will try to fill this gap. It investigates, using experimental data, which of these two models represent a better approximation of subjects' preferences.

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Bibliographic Info

Paper provided by Max Planck Institute of Economics, Strategic Interaction Group in its series Papers on Strategic Interaction with number 2005-20.

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Length: 16 pages
Date of creation: Jul 2005
Date of revision:
Handle: RePEc:esi:discus:2005-20

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Keywords: Expected utility; Mean variance; preference functional; pair wise choice; experiments;

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References

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  1. Hey, John D. & Carbone, Enrica, 1995. "Stochastic choice with deterministic preferences: An experimental investigation," Economics Letters, Elsevier, vol. 47(2), pages 161-167, February.
  2. Levy, H & Markowtiz, H M, 1979. "Approximating Expected Utility by a Function of Mean and Variance," American Economic Review, American Economic Association, vol. 69(3), pages 308-17, June.
  3. Hey, John D., 1995. "Experimental investigations of errors in decision making under risk," European Economic Review, Elsevier, vol. 39(3-4), pages 633-640, April.
  4. Carbone, Enrica, 1997. "Investigation of stochastic preference theory using experimental data," Economics Letters, Elsevier, vol. 57(3), pages 305-311, December.
  5. Holt, Charles A, 1986. "Preference Reversals and the Independence Axiom," American Economic Review, American Economic Association, vol. 76(3), pages 508-15, June.
  6. Loomes, G. & Moffatt, P.G. & Sugden, R., 1998. "A Microeconometric Test of Alternative Stochastic Theories of Risky Choice," University of East Anglia Discussion Papers in Economics 9806, School of Economics, University of East Anglia, Norwich, UK..
  7. John Hey, . "Does Repetition Improve Consistency?," Discussion Papers 99/28, Department of Economics, University of York.
  8. Harless, David W & Camerer, Colin F, 1994. "The Predictive Utility of Generalized Expected Utility Theories," Econometrica, Econometric Society, vol. 62(6), pages 1251-89, November.
  9. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  10. Vuong, Quang H, 1989. "Likelihood Ratio Tests for Model Selection and Non-nested Hypotheses," Econometrica, Econometric Society, vol. 57(2), pages 307-33, March.
  11. Kroll, Yoram & Levy, Haim & Markowitz, Harry M, 1984. " Mean-Variance versus Direct Utility Maximization," Journal of Finance, American Finance Association, vol. 39(1), pages 47-61, March.
  12. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
  13. John Hey & Enrica Carbone, . "Which Error Theory is Best?," Discussion Papers 99/31, Department of Economics, University of York.
  14. Carbone, Enrica, 1997. "Discriminating between Preference Functionals: A Monte Carlo Study," Journal of Risk and Uncertainty, Springer, vol. 15(1), pages 29-54, October.
  15. Hey, John D & Orme, Chris, 1994. "Investigating Generalizations of Expected Utility Theory Using Experimental Data," Econometrica, Econometric Society, vol. 62(6), pages 1291-1326, November.
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Cited by:
  1. Andrea Morone & Ulrich Schmidt, 2005. "An Experimental Investigation of Alternatives to Expected Utility Using Pricing Data," Papers on Strategic Interaction 2005-28, Max Planck Institute of Economics, Strategic Interaction Group.
  2. Morone, Andrea & Morone, Piergiuseppe, 2012. "Are small groups expected utility?," MPRA Paper 38198, University Library of Munich, Germany.
  3. Morone, Andrea, 2010. "On price data elicitation: A laboratory investigation," Journal of Behavioral and Experimental Economics (formerly The Journal of Socio-Economics), Elsevier, vol. 39(5), pages 540-545, October.
  4. Morone, Andrea & Ozdemir, Ozlem, 2012. "Black swan protection: an experimental investigation," MPRA Paper 38842, University Library of Munich, Germany.

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