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Market failure in light of non-expected utility

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  • Eyal Baharad
  • Doron Kliger

Abstract

This paper merges the non-expected utility approach (Tversky and Kahneman, J Risk Uncertain 5:297–323, 1992 and Quiggin, J Econ Behav Organ 3:323–343, 1982 ) into Akerlof’s (Quart J Econ 84:488–500, 1970 ) model of Market for Lemons. We derive the results for different probability weighting functions and analyze the phenomenon of market failure in light of non-expected utility maximization. Our main finding suggests that when the proportion of traded lemons is high (low), the problem of market failure is mitigated (enhanced). In addition, for the case of Cumulative Prospect Theory, we show that (a) the higher the loss aversion is, the more pronounced is the market failure; (b) gain-domain elevation is negatively related to the extent of market failure; and (c) the value function is (i) negatively monotonic in the gain-domain diminishing sensitivity parameter when the market is characterized by a high proportion of “peaches,” and (ii) positively monotonic in the loss-domain diminishing sensitivity parameter when the market is characterized by a high proportion of “lemons.” Copyright Springer Science+Business Media New York 2013

Suggested Citation

  • Eyal Baharad & Doron Kliger, 2013. "Market failure in light of non-expected utility," Theory and Decision, Springer, vol. 75(4), pages 599-619, October.
  • Handle: RePEc:kap:theord:v:75:y:2013:i:4:p:599-619
    DOI: 10.1007/s11238-013-9377-0
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    References listed on IDEAS

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    More about this item

    Keywords

    Decision analysis; Market for lemons; Prospect theory; Rank-dependent expected utility; Utility-preference; D81; D82;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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