A note about loss aversion in terms of bounded cardinal utility theory

Miller, Anne (2024): A note about loss aversion in terms of bounded cardinal utility theory.

Abstract

Bounded cardinal utility theory (BCUT), built on the seminal work of Van Praag (1968), is based on three axioms. • The leaning-S-shaped utility function reflects the individual’s experiences of fulfilment of a need – deprivation (increasing marginal utility (MU)), subsistence (a point of inflection), sufficiency (diminishing MU), and either satiation at finite consumption with the possibility of surfeit, or satiation at infinite consumption, and with an intensity-of-need parameter. • Bounded cardinal utility, (between 0 and 1), enables interpersonal welfare comparisons to be made and partially solves the non-measurability problem of utility (Van Praag, 1968). • A separability rule states that the utilities of commodities fulfilling the same need are weakly separable (multiplicative) and those of commodities fulfilling two separate needs are strongly separable (additive).

Walasek et al (2024) point out that ‘there was never a clear psychological theory about the causes of loss aversion’. BCUT identifies (variable) MU as ‘the psychological value of losses compared to equivalent gains’ associated with endowments of unearned consumption. A leaning-S-shaped utility function represents increasing ‘gain appeal’ when the individual’s endowments are less than subsistence, and the theory predicts that (decreasing) loss aversion occurs only if the individual experiences sufficiency and thus is not deprived of consumption. The steepness parameter, lambda, could be measured by subsistence / intensity-of-need, for choices within one need, or by an individual’s relative-intensities-of-need parameters (ratio of intensities-of-need parameters), for choices involving two needs.

This note suggests that BCUT might provide a clearer psychological basis for the analysis of loss aversion than current practice.

• Item Type: MPRA Paper
• Language: English
• Keywords: loss aversion, prospect theory, valuation, leaning-S-shaped utility, diminishing marginal utility
• Subjects: D - Microeconomics > D1 - Household Behavior and Family Economics > D11 - Consumer Economics: Theory; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty; J - Labor and Demographic Economics > J2 - Demand and Supply of Labor > J22 - Time Allocation and Labor Supply

References

Johnson, Norman L. and Kotz, Samuel Continuous univariate distributions -1. Boston: Houghton Mifflin (Wiley), 1970.

Miller, A. (2024a). The concept of separate needs in cardinal utility theory: a functional form for added leaning-S-shaped utilities. MPRA paper no. 121455, mpra.ub.uni-muenchen.de.

Miller, A. (2024b). The concept of separate needs in cardinal utility theory: the leisure-consumption choice. MPRA paper no.121671, mpra.ub.uni-muenchen.de.

Van Praag, B. M. S. (1968). Individual Welfare Functions and Consumer Behavior: A Theory of Rational Irrationality. Amsterdam: North-Holland

Walasek, L., Mullett, T. L., & Stewart, N. (2024). A meta-analysis of loss aversion in risky contexts, Journal of Economic Psychology, 103 (August 2024), 1027-40.