An Alternative to Prospect Theory

Liang Zou

This paper presents a new approach to decision-making under risk. Preference over risky prospects is defined as a triadic reference-dependent relation in a sense similar to Sugden (2003). Characterized by a set of von Neumann-Morgenstern-style axioms, a new reference-dependent representation theory called compound utility theory (CUT) is obtained which accommodates nonlinear preferences (in probabilities) without invoking the probability-transformation assumption of cumulative prospect theory. Given any opportunity set, a unique reference level can be identified which is consistent with CUT and which enables one to study preferences over both relative changes and absolute levels of wealth simultaneously.

Key Words: Expected utility theory; Cumulative prospect theory; Compound utility theory; Reference-dependence; Nonlinear preference; Triadic preference relation; Utility-reward; Disutility-risk.
JEL Classification Numbers: D81