The Standard Model of Rational Risky Decision-Making

Kazem Falahati
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Kazem Falahati: Glasgow School for Business and Society, Glasgow Caledonian University, 70 Cowcaddens Road, Glasgow G4 0BA, UK

JRFM, 2021, vol. 14, issue 4, 1-24

Abstract: Expected utility theory (EUT) is currently the standard framework which formally defines rational decision-making under risky conditions. EUT uses a theoretical device called von Neumann–Morgenstern utility function, where concepts of function and random variable are employed in their pre-set-theoretic senses. Any von Neumann–Morgenstern utility function thus derived is claimed to transform a non-degenerate random variable into its certainty equivalent. However, there can be no certainty equivalent for a non-degenerate random variable by the set-theoretic definition of a random variable, whilst the continuity axiom of EUT implies the existence of such a certainty equivalent. This paper also demonstrates that rational behaviour under utility theory is incompatible with scarcity of resources, making behaviour consistent with EUT irrational and justifying persistent external inconsistencies of EUT. A brief description of a new paradigm which can resolve the problems of the standard paradigm is presented. These include resolutions of such anomalies as instant endowment effect, asymmetric valuation of gains and losses, intransitivity of preferences, profit puzzle as well as the St. Petersburg paradox.

Keywords: decision-making; rationality; risk; expected utility; behavioural puzzles (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2021
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