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Iterated Expectations Under Rank-dependent Expected Utility And Model Consistency

Alex Stomper and Marie-Louise Vierø ()
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Marie-Louise Vierø: Queen's University

Authors registered in the RePEc Author Service: Marie-Louise Vierø

No 1228, Working Paper from Economics Department, Queen's University

Abstract: Under expected utility theory, compound lotteries can be valued by "iterating" expectations: the expected utility of a compound lottery is the expected value of a simple lottery over prizes that are certainty equivalents to follow-up lotteries. We derive necessary and sufficient conditions for a similar valuation technique in the framework of rank-dependent expected utility (RDU) when a decision maker has to choose between prospects that belong to a comonotonic class and his preferences satisfy consequentialism. The conditions are so restrictive that they can be viewed as an impossibility result. Our contribution thus identifies a challenge for future research. If we accept RDU as the model of behavior, we either need to find alternative valuation algorithms, or we need to relax the assumption of preference exogeneity.

Keywords: model consistency; Iterated expectations; rank-dependent expected utility; valuation methods; conditioning; dynamic consistency; consequentialism; probability weighting function; updating (search for similar items in EconPapers)
JEL-codes: D80 D84 (search for similar items in EconPapers)
Pages: 19 pages
Date: 2015-05
New Economics Papers: this item is included in nep-cbe, nep-neu and nep-upt
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