Abstract
The terms ‘negative utility of gambling’ and ‘risk aversion’ conflate three things:
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(i)
Disutility from the mere act of taking a chance: i.e. negative effects that would not exist if there were no risk or uncertainty, effects which include serious business considerations such as the availability of loans — exemplified in von Neumann and Morgenstern's famous 1947 Appendix;
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(ii)
Diminishing marginal utility of money: — exemplified in Bernoulli and Cramer's expected utility procedure; and
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(iii)
A preference for safety: — exemplified in the rank dependent utility models of Allais, Lopes, Quiggin and Yaari.
Factor (iii) has not been previously distinguished from (i). Factor (i) is regularly either confused with (ii) or ignored as elusive and unimportant.
The paper shows that (i) should not be ignored since it is crucial in many serious business decisions, and need not remain elusive. To separate (i) from (ii) and (iii), and consistently incorporate (i), (ii) and (iii) in decision models, the paper identifies progressive stages in people's knowledge of the future and decomposes people's overall valuation of an option into three steps: 1 utilities distinctive to each of its possible outcomes; 2 utility common to all its possible outcomes; 3 aggregation rules for forming the overall valuation out of 1 and 2. The separation procedure is illustrated and the ambiguity of current decision models with respect to (i), (ii) and (iii) delineated.
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Pope, R. Towards a more precise decision framework. Theor Decis 39, 241–265 (1995). https://doi.org/10.1007/BF01082054
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DOI: https://doi.org/10.1007/BF01082054