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Separating marginal utility and probabilistic risk aversion

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Abstract

This paper is motivated by the search for one cardinal utility for decisions under risk, welfare evaluations, and other contexts. This cardinal utility should have meaningprior to risk, with risk depending on cardinal utility, not the other way around. The rank-dependent utility model can reconcile such a view on utility with the position that risk attitude consists of more than marginal utility, by providing a separate risk component: a ‘probabilistic risk attitude’ towards probability mixtures of lotteries, modeled through a transformation for cumulative probabilities. While this separation of risk attitude into two independent components is the characteristic feature of rank-dependent utility, it had not yet been axiomatized. Doing that is the purpose of this paper. Therefore, in the second part, the paper extends Yaari's axiomatization to nonlinear utility, and provides separate axiomatizations for increasing/decreasing marginal utility and for optimistic/pessimistic probability transformations. This is generalized to interpersonal comparability. It is also shown that two elementary and often-discussed properties — quasi-convexity (‘aversion’) of preferences with respect to probability mixtures, and convexity (‘pessimism’) of the probability transformation — are equivalent.

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Wakker, P. Separating marginal utility and probabilistic risk aversion. Theor Decis 36, 1–44 (1994). https://doi.org/10.1007/BF01075296

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