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Certain And Uncertain Utility: The Allais Paradox And Five Decision Theory Phenomena

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Executive Summary

In the study of decision making under risk, preferences are assumed to be continuous. The authors present a model of discontinuous preferences over certain and uncertain outcomes. Using existing parameter estimates for certain and uncertain utility, five important decision theory phenomena are discussed: the certainty effect, experimentally observed probability weighting, the uncertainty effect, extreme experimental risk aversion and quasi-hyperbolic discounting. All five phenomena can be resolved. The Allais common consequence and common ratio paradoxes are known in decision theory as the primary departures from expected utility. Their appeal is that even without experimentation they ring true, and with experimentation they are found to be robust.

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