Is There A Plausible Theory for Risky Decisions

Abstract

A large literature is concerned with analysis and empirical application of theories of decision making for environments with risky outcomes. Expected value theory has been known for centuries to be subject to critique by St. Petersburg paradox arguments. More recently, theories of risk aversion have been critiqued with calibration arguments applied to concave utility of payoffs. This paper extends the calibration critique to decision theories that represent risk aversion with transformation of probabilities, and thereby makes clear that questioning the plausibility of theories of risk aversion is not synonymous with questioning the plausibility of decreasing marginal utility of money. Testable calibration propositions are derived that apply to dual expected utility theory as well as expected utility theory, cumulative prospect theory, and rank dependent utility theory. Heretofore, calibration critiques of theories of risk aversion have been based on thought experiments. This paper reports real experiments that provide data on the empirical relevance of the calibration critique to evaluating the plausibility of theories of risk aversion. The paper also discusses implications of the data for prospect theory with (editing of) variable reference payoffs and for some recent additions to specialized literature on risky decisions. In addition, the paper reports an experiment with a finite St. Petersburg bet that adds to data inconsistent with risk neutrality.

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