Target-Adjusted Utility Functions and Expected-Utility Paradoxes

Mark Schneider () and Robert Day ()
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Mark Schneider: Economic Science Institute, Chapman University, Orange, California 92866
Robert Day: School of Business, University of Connecticut, Storrs, Connecticut 06269

Management Science, 2018, vol. 64, issue 1, 271-287

Abstract: Experimental tests of expected-utility theory (EU) have accumulated empirical observations in which the predictions of EU are systematically violated. The cumulative prospect theory (CPT) explains violations such as the Allais paradoxes and fourfold pattern of risk attitudes as resulting from nonlinear probability transformations. Here we show that the classical paradoxes for decisions under risk can be explained with preferences that are linear in probabilities for any choice set and that maximize an expected-utility function with respect to an endogenous target return. We introduce the maximin payoff as a plausible and even natural target return from a choice set and show that the resulting target-adjusted utility (TAU) model explains additional empirical observations such as the scale dependence of the Allais paradox that cannot be explained by standard specifications of CPT. Further, using data from three prominent laboratory experiments, we find that TAU is effective in explaining observed behaviors.

Keywords: downside risk; prospect theory; Allais paradox; fourfold pattern (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (6)

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