The arguments of utility: Preference reversals in expected utility of income models
- 466 Downloads
There is a debate in the literature about the arguments of utility in expected utility theory. Some implicitly assume utility is defined on final wealth whereas others argue it may be defined on initial wealth and income separately. I argue that making income and wealth separate arguments of utility has important implications that may not be widely recognized. A framework is presented that allows the unified treatment of expected utility models and anomalies. I show that expected utility of income models can predict framing induced preference reversals, a willingness to pay-willingness to accept gap for lotteries, and choice-value preference reversals. The main contribution is a theorem. It is proved that for all utility functions where initial wealth and income enter separately, either there will be preference reversals or preferences can be represented by a utility function defined on final wealth alone.
KeywordsExpected utility theory Risk aversion Preference reversals
JEL ClassificationC90 D81
I am grateful to Thomas Epper, Jacob Goeree, Konrad Mierendorff, Chris Starmer, Jingjing Zhang, and participants at the FUR XIV International Conference at Newcastle University, as well as the editor and one anonymous referee, for comments. I would like to thank the Swiss National Science Foundation (grant SNSF 138162) and the European Research Council (grant ESEI-249433) for financial support.
- Grether, D.M., & Plott, C.R. (1979). Economic theory of choice and the preference reversal phenomenon. The American Economic Review, 69, 623–638.Google Scholar
- Knetsch, J.L. (1989). The endowment effect and evidence of nonreversible indifference curves. American Economic Review, 79, 1277–1284.Google Scholar
- Savage, L.J. (1954). The foundation of statistics. New York: Wiley.Google Scholar
- von Neumann, J., & Morgenstern, O. (1947). Theory of games and economic behavior. Princeton: Princeton University Press.Google Scholar
- Wakker, P.P. (2005). Formalizing reference dependence and initial wealth in Rabin’s calibration theorem. http://people.few.eur.nl/wakker/pdf/calibcsocty05.pdf.