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Another Solution for Allais Paradox: Preference Imprecision, Dispersion and Pessimism

Bayrak, Oben (2016): Another Solution for Allais Paradox: Preference Imprecision, Dispersion and Pessimism.

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Abstract

Although there are alternative models which can explain the Allais paradox with non-standard preferences, they do not take the emerging evidence on preference imprecision into account. The imprecision is so far incorporated into these models by adding a stochastic specification implying the errors that subjects make. However, there is also the inherent part of the preference imprecision which does not diminish with experience provided in repeated experiments and these stochastic specifications cannot explain a significant portion of the observed behavior in experiments. Moreover, evidence on imprecision suggests that subjects exhibit higher imprecision for a lottery with a higher variance. This paper presents a new model for decision under risk which takes into account the findings of the literature. Looking at the indifference curves predicted by the new model, the new model acts like a mixture of Expected Utility Theory and Rank Dependent Utility Theory depending on which part of the probability triangle the lottery is located.

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