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Eliciting von Neumann-Morgenstern Utilities When Probabilities Are Distorted or Unknown

  • Peter Wakker

    (Medical Decision Making Unit, University of Leiden, Leiden, The Netherlands)

  • Daniel Deneffe

    (The Fuqua School of Business, Duke University, Durham, North Carolina 27706 and Management Education Institute, Arthur D. Little. Inc., Brussels, Belgium)

This paper proposes a new method, the (gamble-)tradeoff method, for eliciting utilities in decision under risk or uncertainty. The elicitation of utilities, to be used in the expected utility criterion, turns out to be possible even if probabilities are ambiguous or unknown. A disadvantage of the tradeoff method is that a few more questions usually must be asked to clients. Also, the lotteries that are needed are somewhat more complex than in the certainty-equivalent method or in the probability-equivalent method. The major advantage of the tradeoff method is its robustness against probability distortions and misconceptions, which constitute a major cause of violations of expected utility and generate inconsistencies in utility elicitation. Thus the tradeoff method retains full validity under prospect theory, rank-dependent utility, and the combination of the two, i.e., cumulative prospect theory. The tradeoff method is tested for monetary outcomes and for outcomes describing life-duration. We find higher risk aversion for life duration, but the tradeoff method elicits similar curvature of utility. Apparently the higher risk aversion for life duration is due to more pronounced deviations from expected utility.

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Article provided by INFORMS in its journal Management Science.

Volume (Year): 42 (1996)
Issue (Month): 8 (August)
Pages: 1131-1150

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Handle: RePEc:inm:ormnsc:v:42:y:1996:i:8:p:1131-1150
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