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Risk and tradeoffs

Abstract

© 2014, Springer Science+Business Media Dordrecht. The orthodox theory of instrumental rationality, expected utility (EU) theory, severely restricts the way in which risk-considerations can figure into a rational individual's preferences. It is argued here that this is because EU theory neglects an important component of instrumental rationality. This paper presents a more general theory of decision‐making, risk-weighted expected utility (REU) theory, of which expected utility maximization is a special case. According to REU theory, the weight that each outcome gets in decision‐making is not the subjective probability of that outcome; rather, the weight each outcome gets depends on both its subjective probability and its position in the gamble. Furthermore, the individual's utility function, her subjective probability function, and a function that measures her attitude towards risk can be separately derived from her preferences via a Representation Theorem. This theorem illuminates the role that each of these entities plays in preferences, and shows how REU theory explicates the components of instrumental rationality.

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