Risky Curves: From Unobservable Utility to Observable Opportunity Sets
University of California, Santa Cruz - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)
Yale University - School of Management
June 6, 2011
Cowles Foundation Discussion Paper No. 1819
Most theories of risky choice postulate that a decision maker maximizes the expectation of a Bernoulli (or utility or similar) function. We tour 60 years of empirical search and conclude that no such functions have yet been found that are useful for out-of-sample prediction. Nor do we find practical applications of Bernoulli functions in major risk-based industries such as finance, insurance and gambling. We sketch an alternative approach to modeling risky choice that focuses on potentially observable opportunities rather than on unobservable Bernoulli functions.
Number of Pages in PDF File: 30
Keywords: expected utility, risk aversion, St. Petersburg Paradox, decisions under uncertainty, option theory
JEL Classification: C91, C93, D11, D81, G11, G12, G22, L83
Date posted: June 10, 2011 ; Last revised: August 22, 2011
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