Cautious Expected Utility and the Certainty Effect
AbstractMany violations of the Independence axiom of Expected Utility can be traced to subjects' attraction to risk-free prospects. Negative Certainty Independence, the key axiom in this paper, formalizes this tendency. Our main result is a utility representation of all preferences over monetary lotteries that satisfy Negative Certainty Independence together with basic rationality postulates. Such preferences can be represented as if the agent were unsure of how risk averse to be when evaluating a lottery p; instead, she has in mind a set of possible utility functions over outcomes and displays a cautious behavior: she computes the certainty equivalent of p with respect to each possible function in the set and picks the smallest one. The set of utilities is unique in a well-defined sense. We show that our representation can also be derived from a `cautious' completion of an incomplete preference relation.
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Bibliographic InfoPaper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 488.
Date of creation: 2013
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