Subjective Expected Utility Theory with 'Small Worlds'
27 Pages Posted: 18 Dec 2009
Date Written: November 30, 2009
We model the notion of a "small world" as a context dependent state space embedded into the "grand world". For each situation the decision maker creates a "small world" reflecting the events perceived to be relevant for the act under consideration. The "grand world" is represented by an event space which is a more general construction than a state space. We retain preference axioms similar in spirit to the Savage axioms and obtain, without abandoning linearity of expectations, a subjective expected utility theory which allows for an intuitive distinction between risk and uncertainty. We also obtain separation of subjective probability and utility as in the state space models.
Keywords: subjective expected utility, decision making under uncertainty, uncertainty aversion, Ellsberg paradox
JEL Classification: D8, G12
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