Non-Expected Utility and Stochastic Dominance
Most of the economic and finance models that deal with investment decision making under uncertainty are based on the expected utility paradigm. However, experimental studies have shown that subjects often behave in a manner that runs counter to expected utility maximization. Such inconsistencies have been shown to be mainly due to violation of the independent axiom (called also the interchangeability axiom, see Chapter 2). In this chapter, we discuss some of the violations of the expected utility model (for a fuller account, see Machina, [1982 and 1983]1), and review the modified of the expected utility theory, the generalized expected utility or non-expected utility theory, as well as the competing models that have been developed in order to avoid these violations.
KeywordsUtility Function Utility Theory Prospect Theory Stochastic Dominance Expect Utility Theory
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- 1.Machina, Mark A., “‘Expected Utility’ Analysis Without Independent Axiom,” Econometrica, 50, 1982, pp. 270–323.Google Scholar
- Machina, M.A., “Generalized Expected Utility Analysis and the Nature of Observed Violations of the Independence Axiom, in Stigum, B., and Wenstøph, F. (eds.) Foundation of Utility and Risk with Applications, Reidel, Dordrecht, Holland, 1983.Google Scholar