Lottery Valuation Using the Aspiration/Relative Utility Function

Warsaw School of Economics, Department of Applied Econometrics Working Paper No. 5-09

26 Pages Posted: 24 Jul 2009

Date Written: July 22, 2009

Abstract

The paper presents a method for lottery valuation using the relative utility function. This function was presented by Kontek (2009) as 'the aspiration function' and resembles the utility curve proposed by Markowitz (1952A). The paper discusses lotteries with discrete and continuous outcome distributions as well as lotteries with positive, negative and mixed outcomes providing analytical formulas for certainty equivalents in each case. The solution is similar to the Expected Utility Theory approach and does not use the probability weighting function – one of the key elements of Prospect Theory. Solutions to several classical behavioral problems, including the Allais paradox, are presented, demonstrating that the method can be used for valuing lotteries even in more complex cases of outcomes described by a combination of Beta distributions. The paper provides strong arguments against Prospect Theory as a model for describing human behavior and lays the foundations for Relative Utility Theory – a new theory of decision making under conditions of risk.

Keywords: lottery valuation, expected utility theory, Markowitz hypothesis, prospect/cumulative prospect theory, aspiration/relative utility function

JEL Classification: D03, D81

Suggested Citation

Kontek, Krzysztof, Lottery Valuation Using the Aspiration/Relative Utility Function (July 22, 2009). Warsaw School of Economics, Department of Applied Econometrics Working Paper No. 5-09, Available at SSRN: https://ssrn.com/abstract=1437420 or http://dx.doi.org/10.2139/ssrn.1437420

Krzysztof Kontek (Contact Author)

Warsaw School of Economics (SGH) ( email )

aleja Niepodleglosci 162
PL-Warsaw, 02-554
Poland

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