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The Distorted Theory of Rank-Dependent Expected Utility

Author

Listed:
  • Hui Huang

    (Faculty of Business Administration, University of Regina)

  • Shunming Zhang

    (China Financial Policy Research Center, Renmin University of China)

Abstract

This paper re-examines the rank-dependent expected utility theory. Firstly, we follow Quiggin's assumption (Quiggin 1982) to deduce the rank-dependent expected utility formula over lotteries and hence extend it to the case of general random variables. Secondly, we utilize the distortion function which reflects decision-makers' beliefs to propose a distorted independence axiom and then to prove the representation theorem of rank-dependent expected utility. Finally, we make direct use of the distorted independence axiom to explain the Allais paradox and the common ratio effect.

Suggested Citation

  • 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.
    • Handle: RePEc:cuf:journl:y:2011:v:12:i:2:p:233-263
    as

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    References listed on IDEAS

    as
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    5. Roell, Ailsa A, 1987. "Risk Aversion in Quiggin and Yaari's Rank-Order Model of Choice under Uncertainty," Economic Journal, Royal Economic Society, vol. 97(388a), pages 143-159, Supplemen.
    6. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    7. Hong, Chew Soo & Karni, Edi & Safra, Zvi, 1987. "Risk aversion in the theory of expected utility with rank dependent probabilities," Journal of Economic Theory, Elsevier, vol. 42(2), pages 370-381, August.
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    More about this item

    Keywords

    Expected utility; Rank-dependent expected utility; Distortion function; Distorted independence axiom; The Allais paradox; The Common ratio effect;
    All these keywords.

    JEL classification:

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

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