The Distorted Theory of Rank-Dependent Expected Utility

Hui Huang and Shunming Zhang
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Hui Huang: Faculty of Business Administration, University of Regina
Shunming Zhang: China Financial Policy Research Center, Renmin University of China

Annals of Economics and Finance, 2011, vol. 12, issue 2, pages 233-263

Abstract: This paper re-examines the rank-dependent expected utility theory. Firstly, we follow Quiggin's assumption (Quiggin 1982) to deduce the rank-dependent expected utility formula over lotteries and hence extend it to the case of general random variables. Secondly, we utilize the distortion function which reflects decision-makers' beliefs to propose a distorted independence axiom and then to prove the representation theorem of rank-dependent expected utility. Finally, we make direct use of the distorted independence axiom to explain the Allais paradox and the common ratio effect.

Keywords: Expected utility; Rank-dependent expected utility; Distortion function; Distorted independence axiom; The Allais paradox; The Common ratio effect (search for similar items in EconPapers)
JEL-codes: D81 (search for similar items in EconPapers)
Date: 2011
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Persistent link: http://EconPapers.repec.org/RePEc:cuf:journl:y:2011:v:12:i:2:p:233-263

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