Contents. Expected utility
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1 Table of Preface page xiii Introduction 1 Prospect theory 2 Behavioral foundations 2 Homeomorphic versus paramorphic modeling 3 Intended audience 3 Attractive feature of decision theory 4 Structure 4 Preview 5 Our five-step presentation of decision models 7 Part I Expected utility 1 The general model of decision under uncertainty and no-arbitrage (expected utility with known utilities and unknown probabilities) Basic definitions Basic properties of preferences Expected value Data fitting for expected value The bookmaking argument of de Finetti, or the no-arbitrage condition from finance A behavioral foundation of subjective probabilities and expected value using no-arbitrage and no-book Discussion of Structural Assumption (Decision under uncertainty) The general nature and usefulness of behavioral foundations Appendix: Natural, technical, and intuitive preference conditions, and the problematic completeness condition Appendix: The relation of Theorem to the literature Appendix: Proof of Theorem and Observation v
2 Table of vi 2 Expected utility with known probabilities risk and unknown utilities Decision under risk as a special case of decision under uncertainty Decision under risk: basic concepts Decision under risk as a special case of decision under uncertainty; continued Choices under risk and decision trees Expected utility and utility measurement Consistency of measurement and a behavioral foundation of expected utility Independence and other preference conditions for expected utility Basic choice inconsistencies Appendix: Proof of Theorem and Observation Applications of expected utility for risk An application from the health domain: decision tree analysis Risk aversion Applications of risk aversion Indexes of risk aversion Parametric families of utility Data fitting for expected utility under risk Multiattribute utility Taxation and welfare theory with cardinal utility Proofs for Chapter Expected utility with unknown probabilities and unknown utilities Fifteen preference questions (Subjective) expected utility Measuring utility and testing EU for } A decision process General utility measurement and the tradeoff notation A behavioral foundation of expected utility Further discussion of Theorem (Uncertainty-EU) Further implications of expected utility Savage s sure-thing principle Utility analysis based on t-indifferences Debreu s additive decomposability and state-dependent utility A hybrid case: subjective probabilities and utilities when also objective probabilities are given A general ( single-stage ) approach 119
3 Table of vii A behavioral foundation for the single-stage approach The multi-stage approach of Anscombe & Aumann (1963) Comparing the Anscombe & Aumann model with the single-stage approach Data fitting for expected utility under uncertainty A statistical analysis of the experiment of }4.1, revealing violations of expected utility The Allais paradox: a well-known violation of expected utility Appendix: Experimental economics real-incentive principle and the tradeoff method Appendix: Tradeoff consistency as a generalization of de Finetti s bookmaking Appendix: Proofs for Chapter Part II Nonexpected utility for risk 5 Heuristic arguments for probabilistic sensitivity and rank dependence Probabilistic sensitivity versus outcome sensitivity for single-nonzero-outcome-prospects Probabilistic sensitivity for multi-outcome prospects, and the old way of transforming probabilities A violation of stochastic dominance Rank-dependent utility: discovering the formula using psychological intuition Rank-dependent utility: discovering the formula using mathematical intuition Calculating rank-dependent utility Conclusion Probabilistic sensitivity and rank dependence analyzed Ranks, ranked probabilities, and rank-dependent utility defined Ranks, ranked probabilities, and rank-dependent utility discussed Where rank-dependent utility deviates from expected utility: optimism and pessimism Further deviations of rank-dependent utility from expected utility The certainty effect Further discussion of rank dependence What rank-dependent utility shares with expected utility Measuring utility under rank-dependent utility A behavioral foundation of rank-dependent utility An elaborated example Abdellaoui s method of measuring probability weighting Further implications of rank-dependent utility 188
4 Table of viii 6.6 Appendix: Yet further deviations of rank-dependent utility from expected utility Appendix: Ranking identical outcomes and collapsing outcomes Appendix: An interpretation of rank-dependent utility using the derivative of w Appendix: RDU for continuous distributions and figures for negative outcomes Applications and extensions of rank dependence Likelihood insensitivity and pessimism as two components of probabilistic risk attitudes Parametric forms of weighting functions Data fitting for rank-dependent utility under risk Direct ways to test convexity, concavity, and likelihood insensitivity using violations of the sure-thing principle An alternative direct way to directly investigate properties of nonlinear decision weights Bad-news probabilities or loss-ranks A formal definition of likelihood insensitivity (inverse-s) The choice of insensitivity region Discussion of likelihood insensitivity Indexes of pessimism and likelihood insensitivity Binary rank-dependent utility Appendix: Alternative definition of likelihood insensitivity: first concave and then convex Appendix: Proofs for Chapter Where prospect theory deviates from rank-dependent utility and expected utility: reference dependence versus asset integration A choice paradox A discussion and the real culprit of the paradox Deviations from a fixed reference point ( initial wealth ) as nothing but an alternative way of modeling final wealth, and of incorporating some empirical improvements Loss aversion defined Deviations from a variable reference point as a major breakaway from final-wealth models Rabin s paradox Future directions for theories of reference dependence Appendix: Empirical meaningfulness problems of loss aversion Appendix: A formal model of initial wealth and reference points 249
5 Table of ix 9 Prospect theory for decision under risk A symmetry about 0 underlying prospect theory The definition of prospect theory Properties of the prospect theory formula, and calculations What prospect theory shares with rank-dependent utility and with expected utility, and one more reanalysis of the experiment of } Monotonicity, stochastic dominance, and the sure-thing principle Measuring utility, event weighting, and loss aversion Empirical findings on prospect theory Analytical problems of power utility for analyzing loss aversion The first problem: loss aversion depends on the monetary unit The second problem: always U(a) > U( a) for some outcome a > Ways to avoid the problems Appendix: Some theoretical issues concerning prospect theory Appendix: Original prospect theory of Part III Nonexpected utility for uncertainty 10 Extending rank-dependent utility from risk to uncertainty Probabilistic sophistication Rank-dependent utility defined for uncertainty and without probabilistic sophistication Rank-dependent utility and probabilistic sophistication once more Ellsberg s violation of probabilistic sophistication Further observations Where rank-dependent utility under uncertainty deviates from expected utility in the same way as it did under risk Optimism and pessimism Likelihood insensitivity (Inverse-S) Direct ways to test convexity, concavity, and likelihood insensitivity using violations of the sure-thing principle What rank-dependent utility shares with expected utility for uncertainty (in the same way as it did for risk) Rank-preference conditions Measuring utility (and event weighting) under RDU A behavioral foundation for RDU Binary rank-dependent utility A hybrid case: rank-dependent utility for uncertainty when also objective probabilities are given 299
6 Table of x A general ( single-stage ) approach A behavioral foundation for the single-stage approach Schmeidler s and Jaffray s two-stage approaches Bad-news events or loss-ranks Further observations regarding rank dependence Appendix: An integral representation Appendix: Ranking states and collapsing outcomes Appendix: Comonotonicity Appendix: Proofs for Chapter Appendix: Proof of Theorem Ambiguity: where uncertainty extends beyond risk The Ellsberg paradox and the home bias as within-subject between-source comparisons Using rank dependence to analyze ambiguity Elaborated examples for ranks, ambiguity premiums, and hedging in finance The CORE Multiple priors (Maxmin expected utility and a-maxmin): basic results Approaches in the literature that we will not take Indexes of ambiguity aversion Indexes of ambiguity aversion and sensitivity Appendix: Discussion of multiple priors and other models Appendix: Violations of monotonicity for multiple priors Appendix: Möbius transforms and belief functions Prospect theory for uncertainty Prospect theory defined Where prospect theory deviates from rank-dependent utility and expected utility What prospect theory shares with rank-dependent utility and expected utility under uncertainty Sign-preference conditions Measuring utility (and event weighting) under prospect theory Measuring loss aversion under prospect theory A behavioral foundation for prospect theory A hybrid case: prospect theory for uncertainty when also objective probabilities are given Loss aversion versus ambiguity aversion Violations of prospect theory and rank dependence Indexes of ambiguity attitudes under prospect theory 354
7 Table of xi 12.8 Appendix: Some theoretical issues concerning prospect theory for uncertainty Appendix: Proofs for Chapter Conclusion 358 Appendices 359 Appendix A Models never hold perfectly: how to handle their deficiencies? 359 A.1 Nonparametric measurements and parametric fittings for imperfect models: general discussion 359 A.2 Our distance measure for parametric fitting 361 A.3 Discussion of the distance measure 363 Appendix B Choosing from multiple prospects and binary choice: the principles of revealed preference 366 B.1 Examples 367 B.2 A behavioral foundation of preference relations derived from choice behavior 371 B.3 Assumptions underlying revealed preference 374 B.4 The history of revealed preference 378 Appendix C Dynamic decisions 380 Appendix D Applications other than decision under uncertainty 384 Appendix E Bisymmetry-based preference conditions 387 Appendix F Nonmonotonic rank-dependent models and the Fehr Schmidt model of welfare evaluation 391 Appendix G Extensions of finite-dimensional results to infinite-dimensional results: a meta-theorem 393 Appendix H Measure theory 395 Appendix I Related textbooks and surveys 397 Appendix J Elaborations of exercises 399 Appendix K Skipping parts and interdependencies between sections 455 References 461 Author index 492 Subject index 500
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