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An Alternative to Prospect Theory

Author

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  • Liang Zou

    (University of Amsterdam Business School)

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.

Suggested Citation

  • Liang Zou, 2006. "An Alternative to Prospect Theory," Annals of Economics and Finance, Society for AEF, vol. 7(1), pages 1-28, May.
  • Handle: RePEc:cuf:journl:y:2006:v:7:i:1:p:1-28
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    References listed on IDEAS

    as
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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, vol. 12(2), pages 233-263, November.

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    More about this item

    Keywords

    Expected utility theory; Cumulative prospect theory; Compound utility theory; Reference-dependence; Nonlinear preference; Triadic preference relation; Utility-reward; Disutility-risk;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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