CFDP 1819

Risky Curves: From Unobservable Utility to Observable Opportunity Sets

Publication Date: August 2011

Pages: 30

Abstract: 

Most theories of risky choice postulate that a decision maker maximizes the expectation of a Bernoulli (or utility or similar) function. We tour 60 years of empirical search and conclude that no such functions have yet been found that are useful for out-of-sample prediction. Nor do we find practical applications of Bernoulli functions in major risk-based industries such as finance, insurance and gambling. We sketch an alternative approach to modeling risky choice that focuses on potentially observable opportunities rather than on unobservable Bernoulli functions.

Keywords: 

Expected utility, Risk aversion, St. Petersburg Paradox, Decisions under uncertainty, Option theory

JEL Classification Codes:  C91, C93, D11, D81, G11, G12, G22, L83