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Principle of uncertain future and utility

Harin, Alexander (2007): Principle of uncertain future and utility.

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Abstract

The principle of uncertain future: the probability of a future event contains a degree of (hidden) uncertainty. As a result, this uncertainty (in a sense, similar to vibrations, fluctuations) pushes the probability value back from the bounds to the middle of its range (from ~100% and ~0% to the middle probability values). In other words, the real values of high probabilities are lower than the preliminarily determined ones. Conversely, the real values of low probabilities are higher than the preliminarily determined ones. This result provides the uniform solution of a number of fundamental problems: the underweighting of high and the overweighting of low probabilities, the Allais paradox, risk aversion, loss aversion, the Ellsberg paradox, the equity premium puzzle, etc. The principle and its consequences can be applied in the fields of banking, investment, insurance, trade, industry, planning and forecasting. Explanations of the principle and examples of solution of three types of basic utility problems are provided.

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