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A Satiscing Alternative to Prospect Theory

  • David B. BROWN

    (Fuqua School of Business, Duke University)

  • Enrico G. DE GIORGI

    (University of St. Gallen, Swiss Finance Institute and University of Lugano)

  • Melvyn SIM

    (NUS Business School, NUS Risk Management Institute, National University of Singapore)

In this paper, we axiomatize a target-based model of choice that allows decision makers to be both risk averse and risk seeking, depending on the payoff's position relative to a pre- specified target. The approach can be viewed as a hybrid model, capturing in spirit two celebrated ideas: first, the satisficing concept of Simon (1955); second, the switch between risk aversion and risk seeking popularized by the prospect theory of Kahneman and Tversky (1979). Our axioms are simple and intuitive; in order to be implemented in practice, our approach requires only the specification of an aspiration level. We show that this approach is dual to a known approach using risk measures, thereby allowing us to connect to existing theory. Though our approach is intended to be normative, we also show that it resolves the classical paradoxes of Allais (1953) and Ellsberg (1961), neither of which can be explained by expected utility theory.

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Paper provided by Swiss Finance Institute in its series Swiss Finance Institute Research Paper Series with number 09-19.

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Length: 63 pages
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Handle: RePEc:chf:rpseri:rp0919
Contact details of provider: Web page: http://www.SwissFinanceInstitute.ch

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