E den from those who sometimes violate ihem ill

cwbjecrs refused tti believe that they cstilc! have

natized) by Mais ( 1952).
ought to derive weights a funct;on OT :!ndividual ~~rc~bab~it~es,
~~~d~ate difkulties w prDbabi!ities 3f the forx l/n. Severe
unless the weight, ~(l/n) is set equal
with art&nty, and compare it with
ed by a srn~ 11 but pssi tive random
rent vaiues 3; each with probability
chat i:~, ttle certain event is preferred, even thou@ the random variable
has a superior outcome with probability *.
s anomaly is to be avoided, a similar argument will es the
ent that for i 5 ks AT. Consider the choice na
with ~rababii~t~ k,n twith asthi,xg received otherwise),
and k sums of the form X-+x1 (or X-q), each with probability l/n. Thus, if
t of y, denoted c= CE(y). If two
distin@shed.
II= construction of a function I/ on Y such
). The ??M theory involves constructing a
on X md setting V(y) ==E ptU(xi). anda offers the seemingly
symmetrioai proposal V(y) = >z, w(pJx,, where the i are assumed to represent
ntity of a given good md IV is a real-vaiued function on the unit
interval such that w(O)=O. Kahneman and Tversky combine the two, setting
V(y) =& w(p&&,), where the x1 are assumed to represent changes from some
initial situation. Karmarkar suggests setting
,)W(XJ
I
C w(pi), where
i
mentioned above. Kahneman and Tversky themselves pain+ to the difIiculties
which arise with their approach (and c1 jhrtt& that of Handa) when w is
non-linear. Further discussion is given by Karmarkar (1979).
In general, if w is non&tear it is possible to find an overweighted pair of
prohabiities p and 1 -I) such that
w@)+wp-p)> 1. (2)
If xi and x2 are chosen so that x1 is very slightly preferred to x2, then
Yet the prospect xi clearly domin&s ((xl,,xz); @? 1 -p)j irr the strong sense
that its outcome will be preferred (or at least indserent) with probability 1.
Kahneman and Tversky avoid this implication by assuming that dominated
prosmts are edited out but this leads to the undesirable result that
pain&e choices we iritransitive. Note again that, if w is linear, so that
w(p) -6 w(l -B)== w(l) the &ory reduces to that of NM.
A more cornplcx example shows that the problem of dominance applies to
Kqrnarkars theory. Suppose thatt, for some p, w(p)<2w(p,Q). Then we can
findx,Pxp#kJ !pch that
>.
- ~W~pi~l~~-~3~w(~--P)tJ(~3)~/~w(P)I ++ --PI)
329
fpticw of the function k. wuuld at first sight appear to be an
DO bonnd has been imposed on the number of different
ct, yv However, it can be shown that a
1~ [Q, 1-j is sulfkient to dekzmine h(p) for
regardless of its Ir:ngtid. The apptoach used is very
used io show that a non-linear weighting function
ttres will generat: violations of dominance. The central
p&n% is that the ~VhdiO%l Of il prospect, in Which two very simliar
outcomes x1 arrd x2 occur with the probabilities p2 and p2, must be close to
that of a prospect which is identical except that x1 replaces x2, occurring
v&h a t&al probasitity pl +pz, This imposes constraints on the function h. If
it is surncd, w in previous approaches, that h,@) depends only on pr,
then these constraints are satisfied only by the NM expected utility function.
For each pc [Q, 13, write f@) = h,(p, I-- p). Thus, f(p) defmes the behaviour
Of h on p&s fp, 1 -p). ne exknSiOn cJf h to triples f&, p2,p3) Itill n3W be
deskbed in detail. The approach used can be shown by induction to apply
Consider the two prospects y, = ((x,, x2); (pil, 1 - p,)> and y2 = ((x,, x3, x&
(pz,pl -p2, 1 -p,)). As U(x,) approaches U(x,), V(y2) must approach V(yr). At
the limit, x1 .=x3 and y, =y2, so that
+MP29 P-h:, I- Pl))u(X,) + h3& pi --P2,1- pl)U(X,).
(7)
Since x1 and x2 are chosen arbitrkly and h(p) is independent of x the
coe$kients on U(x,) on the right-hand and left-hand sides of (7) must be
equal. Hence.
M72Jv-P2~ 1 -PA= 1 --a
11.
(8)
Conlvzsely, by setting U(x,) close to W(x,) we can show
h@2r PI - ~2% 1 - PI) =,fkd, ad hence (9)
331
~.Mean Ahlw Theorem. Def i ne y$*=( O, . . .,N- l/N;p*) and y,l;=
CW* 6 * * , G&J*
The distributions 9f yft and y$ are given by step functions which lie,
mspective:ly, abovy and below D. It is clear that y$ Py PJ$*~ while
g/(yjt;*) = l/N if,l g(x&jU((i - 1)/N), so that
3. Axioms
In order to generate a theory more general than NM expected utility
theory, :lt is necfi.ssary to begir, with a weaker set of axioms. In particdar, it
seems appropriate to modify the controversial independence axiom.
The notation adopted here creates some difliculties in comparisons of the
two sets of axiaqs, First, it must be noted that acceptance of the NM
complexity axiom (that the value of a compound lottelj depends only en the
uSma& probability of elach outcome) is implicit in the use of this notation. If
this <axiom did not hold, two prospects, both expressed as (x,&, need not bc
of equir-aleqt value. Seqond, the independence and continuity axioms in NM
theoqy rtre signi&aoty weakened if th$y apply only to outcomes x E X.
For Lsta~,ce~ the $dependzace3 axiom:
becomes a simple statement that preferences preserve dominance if yn and y,
are rep&&_ by q@qWs of X (9 Axiom 2).
In ad&ion to the complexity axiom, the usual completeness axiom will be
adopted.
Axiqn .a...
./ /
? is co?plete, reflexive and transitive (completeness).
J . Qpiggiq ..4 tbeory qf anti@m&d wtility 333
The major resuh of this paper is:
Proposit ion 1. Suppose X and Y satisJy R.1 and R.2 and P satisJie,n Axioms
1-4, Then thera exists a function V: Y -+R such that
(i) : V(y) 2 V(y3 ifhIm ogy if yPy,
(ii) V(x;& k& h&)U_(xJ for some functions U and h,
where h(l)= I and h&4)=($,$. If two functions V and V sati& (i) and (ii)
there exists constants a altd b, a > 0, such that
(iii) V(y)=aV(y)-t b.
The proof, which is not very illumin7:rng, is included in the appendix.
It is clear that Axioms l-3 are .~eak forms of the corresponding NM
axioms, Axiom 4 can be derived from t!~ NM independence axiom blat it is
easier to show that any expected utility maximizer must satisfy it, sink
=c*(u(x,) + u(x:))p, =ECU(GP)J .
i
4 Coaditionaii on the aticipated utiiity fumdons
Under the anticipated utility theory, an individuals attitudes to prospects
are determined both by their attitudes to the possible outcome and by their
attitudes tq the probabilities. These are m&ted in the utility functioh 11, and
tl re, +eighting fur&ion, h, respectively..
@th regard tc the first, the con&pts of tisk aversion, risk neutrality and
r:i& prtheticx are still &evant though their interpretation is somewhat
d.@&nt. A $sk neutral in&vi&a! tiil be ind%ercnt between a W-50 bet
a@ its expbcted outcome, while a risk averter will prefer the certain outcome
ai;d a risk preferrer the &et. %&, as in expected utihti theory, risk aversion
is
?!I8
, uivprfc~$ ty a co*ve utiliiy fu&on.
xg@st c#$qyls pi&&n df @obabiity distortion relates to the treatment
o&&s with !Lr&ll $robabihticS and extreme outcomes. We may say that an
i.n$vid,u$ ove?ights extreme events if
*,
335
individual is pessimistic, since the worst outcomes are,
ted. If f(p) s 1 -J (l - p), the individual is optimistic,
dividual is neutral and h is symmetric.
is rather difficult to distinguish empirically
on. It would thus be possible to require U to be linear, as
uid imply dropping the plausible condition
imply coWant relative risk aversion for any
odds. The theory p nted here is more general and flexible.
P&M useful a.pphcations of the Nhrl theory have been based oh the
assumgltion that X is the set of real numbers (Its ek:ments are generally
taken to correspond to levels of real wealth.) The preference ordering P on X
is as~med to correspond to the natural ordering so that individuals always
prefer rrrore wealth to less. These preferencss may be represented by a
monotcotic increasing function U: R-+R. One of the most important tools 01
analysis under these conditions is the concqt of stochastic dominance
[Fishbum (E&54)]. Madar and Russell (1969) have devel,.ped scucbastic
dominance r&s for the NM theory. Given random variables jO and y:,, with
cumukrtive distribution fuxtions D, and D, respectively, t
first stochastically dominate y,, (yl FSD y,) if
Q&)&D,(x) for all x
and to mend StochasticaXy dominate y, (1, SSD yO) if
(17)
(The tmm3 first degree artd second degree stochastic dominance are also
wklely used for these condi%ons.)
Th:y prove4
Propitiofl2. Let yr and y, be as above. Then
(i) yy FSD y. g and only if E[U(y)] 2 E[U(y,)] fir all monotonic increasing
, u.
(ii) yl SSQ yQ jf and only if ECUQ&J ~E[U(yJ for all concave increasing U.
on (1976).
tit se&a,). Then by the mean value theorem,
?I(B,(~)~-ftD,(s))lds~~(Do(ai~~ 4W-W?d~.
(26)
Ql )l
Combining. (23) and (25) yields the desired result (22) for a= 1. Suppose (22)
holds for i=1_2 ,..., k. Then
I
(We(s)) -s(W))) ds Wf(Do(a.,, - ,)I=~ UU4 - &)I ds. (27)
40 0
kpplication of an argument similar ts that for i= 1 to the interval
(azt, fc2k + 2) yie:ds
4, Quiggin, A tltmy oj. antkiputd wility 339
(34). However these do not fit the intuitive conception of skewness as well as
distributions satisfying (34).] A converse argument can be applied if yO is
s&w& to the left, arid yr is either symmetric or skewed to the right.
Just as the expected utility theory permits the analysis of behaviour which
would be excluded as irrational under a profit-maximization hypothesis, the
AU theory permits the analysis of sqticipations which are not mathematical
expectations.
It may be argued that the adoption of a more general theory makes it
harder to ,obtain useful predictions. The results of section 4 show that much
of the dominance analysis which is useful in NM theory can be extended to
AU theory. In particular, Proposition 3 shows that no pairvise preference
rankiti:g whiGh is inadmissible under NM theory can be admissible under AU
theory, Further work is needed in developing conditions under which other
results can be extended.
Areas in which AU theory might usefully be applied include the problem
of individuals apparent propensity to over-insure, and tbts economic
analysis of gambling behavior. The theory is likely tr, be particu.drl! valuable
in the analysis of decisions involving catastrophic (or extremely t:~vourable
outcomes) which occur with low probability.
Appendix
The proof of Proposition 1 has two parts. In part (a) an arbitrary choice of
values for [J for two elements of X is shown to imply that t{v) can have
only one possible value of any YE Z In part (b) it is shown that the function
V constructed in this way satisfies conditions (i) and (ii) oi the proposition. In
both parts of the proof the special status of SO-50 bets is trsed extensively.
(a) Choose x, X E X, xPx and set V(x) =O, U(x3= 1. pn the trivial
w_ when xl;le for $1 x, Y, V must be a constant function and will satisfy
conditions (i) and (ii).]
If x = XE((x,x); (i,&)> then by (ii) and Axiom 2, V(x) =3. More generally,
q U&r) = u/2n, I&c& =( + 1)/2, x = CE((x, :, x2); (3, $)I, U(x) = (24 + n)Pa + l.
Note ihat ~+%cP~; sri that the function U preserves the preference ordering.
The set of numbers, ilf the form u,Qk is dense in LO, l] since every real number
has a binary expsinsion. We may thus coimplete the construction of U on
(x;xPxP$) as6 follows: Let
,.i , I.

The density properties of X* mean that it will be sufikieat to prove the
desired resu! t for y E: Y*
TJle result will first be established for the class, of B-50 bets. Suppose x,
qr ;G~ B Xg and xzPxl. Then we wish to prove
Prrq$ We may note that it is suficient to prove the only if part of the
proposition since, for any x1, 3~~15 X,*, there exists x3 such that U(q)=
~~.(w2M~d~>* ?-II
IS can be seen by examikg the construction
prmdure. Hence the loaly Z proposition implies that xJ = CE(jx,, x,);&$)$
asltd that if x==CE{( xI,x2);(+,$)) then U(x)= U(.Y,). Since x,x1 EX~,
U(x) = u/? for some Q, and
U(x,) = I a I . Q/2& for some kj > 0.
The proposition holds for b= 1 by virtue of the construction
may be proved inductively for arbitrary b by showing that
procedure. It
(ii) Let b -= (bt -t bJ2 and
U(x&=(u-b&2, ,u(x&=(u+b,)/2k,
343
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