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Expected Utility Theory: Rest in Peace?

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  • Hertzler, G.L.

Abstract

From all reports, expected utility theory is dead. The reports are greatly exaggerated. This study makes two modifications which revive expected utility theory. Rather than directly modelling risk preferences by a von Neumann-Morgenstern utility function of wealth, risk preferences and the expected utility of wealth are derived from consumption and investment decisions over time. Rather than using future wealth as the reference point for evaluation risk preferences, current wealth is used instead. The revived theory is both normative and descriptive. It specifies how rational people ought to make decisions under risk and explains the major empirical findings about how people actually make decisions. For example the Allais Paradox and its variations, preference reversals and framing effects all result from rational decisions by uniformly risk-averse people. Moreover, apparently risk-seeking behaviour can result from risk-averse people with low rates of time preference taking risks to save for the future. The revived theory also shows why eliciting certainty equivalents cannot measure peoples' risk preferences but leads to new procedures for measuring both time and risk preferences. (JEL D81, D91).

Suggested Citation

  • Hertzler, G.L., 1995. "Expected Utility Theory: Rest in Peace?," Discussion Papers 232270, University of Western Australia, School of Agricultural and Resource Economics.
    • Handle: RePEc:ags:uwapdp:232270
    DOI: 10.22004/ag.econ.232270
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    References listed on IDEAS

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    1. Hertzler, Greg, 1991. "Dynamic Decisions Under Risk: Applications of Ito Stochastic Control in Agriculture," 1991 Conference (35th), February 11-14, 1991, Armidale, Australia 145902, Australian Agricultural and Resource Economics Society.
    2. Camerer, Colin F & Ho, Teck-Hua, 1994. "Violations of the Betweenness Axiom and Nonlinearity in Probability," Journal of Risk and Uncertainty, Springer, vol. 8(2), pages 167-196, March.
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    More about this item

    Keywords

    Research Methods/ Statistical Methods;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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