Subjective Expected Utility Theory Research Articles

A Critical Comparison of SEUT and Prospect Theory

This article explores two key theories in behavioral finance: Subjective Expected Utility Theory (SEUT) and Prospect Theory, outlining their development as responses to historic economic paradoxes, challenging traditional notions of rationality in economic decision-making. SEUT extends the concepts of expected value and rational choice, incorporating individual utility functions and subjective probabilities. Despite its comprehensive approach, SEUT struggles to explain certain behaviors under risk and uncertainty. Prospect Theory, conceived by Kahneman and Tversky, offers an alternative. It introduces decision weighting, focusing on how individuals differently perceive gains and losses relative to a reference point. This theory explains human biases like loss aversion and framing effects, which SEUT overlooks. Through practical examples and empirical studies, the article demonstrates scenarios where human behavior deviates from SEUT predictions, influenced by psychological factors. However, both theories provide insights into economic decision-making, they have their respective strengths and limitations. The article suggests a more integrated approach, recognizing the complexities of human decision-making in economic contexts.

Bounded rationality, enactive problem solving, and the neuroscience of social interaction.

This article aims to show that there is an alternative way to explain human action with respect to the bottlenecks of the psychology of decision making. The empirical study of human behaviour from mid-20th century to date has mainly developed by looking at a normative model of decision making. In particular Subjective Expected Utility (SEU) decision making, which stems from the subjective expected utility theory of Savage (1954) that itself extended the analysis by Von Neumann and Morgenstern (1944). On this view, the cognitive psychology of decision making precisely reflects the conceptual structure of formal decision theory. This article shows that there is an alternative way to understand decision making by recovering Newell and Simon's account of problem solving, developed in the framework of bounded rationality, and inserting it into the more recent research program of embodied cognition. Herbert Simon emphasized the importance of problem solving and differentiated it from decision making, which he considered a phase downstream of the former. Moreover according to Simon the centre of gravity of the rationality of the action lies in the ability to adapt. And the centre of gravity of adaptation is not so much in the internal environment of the actor as in the pragmatic external environment. The behaviour adapts to external purposes and reveals those characteristics of the system that limit its adaptation. According to Simon (1981), in fact, environmental feedback is the most effective factor in modelling human actions in solving a problem. In addition, his notion of problem space signifies the possible situations to be searched in order to find that situation which corresponds to the solution. Using the language of embodied cognition, the notion of problem space is about the possible solutions that are enacted in relation to environmental affordances. The correspondence between action and the solution of a problem conceptually bypasses the analytic phase of the decision and limits the role of symbolic representation. In solving any problem, the search for the solution corresponds to acting in ways that involve recursive feedback processes leading up to the final action. From this point of view, the new term enactive problem solving summarizes this fusion between bounded and embodied cognition. That problem solving involves bounded cognition means that it is through the problem solver's enactive interaction with environmental affordances, and especially social affordances that it is possible to construct the processes required for arriving at a solution. Lastly the concept of enactive problem solving is also able to explain the mechanisms underlying the adaptive heuristics of rational ecology. Its adaptive function is effective both in practical and motor tasks as well as in abstract and symbolic ones.

A coupled agent-based model for France for simulating adaptation and migration decisions under future coastal flood risk

In this study, we couple an integrated flood damage and agent-based model (ABM) with a gravity model of internal migration and a flood risk module (DYNAMO-M) to project household adaptation and migration decisions under increasing coastal flood risk in France. We ground the agent decision rules in a framework of subjective expected utility theory. This method addresses agent’s bounded rationality related to risk perception and risk aversion and simulates the impact of push, pull, and mooring factors on migration and adaptation decisions. The agents are parameterized using subnational statistics, and the model is calibrated using a household survey on adaptation uptake. Subsequently, the model simulates household adaptation and migration based on increasing coastal flood damage from 2015 until 2080. A medium population growth scenario is used to simulate future population development, and sea level rise (SLR) is assessed for different climate scenarios. The results indicate that SLR can drive migration exceeding 8000 and 10,000 coastal inhabitants for 2080 under the Representative Concentration Pathways 4.5 and 8.5, respectively. Although household adaptation to flood risk strongly impacts projected annual flood damage, its impact on migration decisions is small and falls within the 90% confidence interval of model runs. Projections of coastal migration under SLR are most sensitive to migration costs and coastal flood protection standards, highlighting the need for better characterization of both in modeling exercises. The modeling framework demonstrated in this study can be upscaled to the global scale and function as a platform for a more integrated assessment of SLR-induced migration.

Participative Management and Employee Productivity in Agro- Entrepreneurship Firms in Anambra State

The study examined the participative management and employee productivity in agro-entrepreneurship firms in Anambra state. the objectives of the study were to: examine the effect of direct employee’ participation, consultative employee’ participation, representative employee’ participation employee ownership participation on employee productivity in agro-entrepreneurship firms in Anambra state. However four hypotheses are formulated in line with the objectives. The study were anchored on Subjective Expected Utility theory (SEU) developed by L. J. Savage in 1954. The study adopted survey method of research. Data were generated through primary and secondary sources. The method for data collection was questionnaire which was administered randomly among the staff of the selected firm. The populations of the study were 2244, The sample size of the study is four hundred and thirty-two (432). While three hundred and thirty-two (332) where retrieved. The hypotheses were tested using regression method at 0.05% level of significance. The findings of the study revealed, There was significant relationship between direct employees’ participation in effective decision making and employee productivity in agro-entrepreneurship firms in Anambra state (t-7.761 p-0.00).There was significant relationship between consultative employees’ participation in effective decision making and employee productivity in agro-entrepreneurship firms in Anambra state (t-6.112 p-0.00).There was significant relationship between Representative employees’ participation in effective decision making and employee productivity in agro-entrepreneurship firms in Anambra state (t-2.836 p-0.00).The study recommends that The dimension and scope to which employee participate in organization sensitive issues should be deepened so as to attracts employee trust and commitment.Monthly or quarterly meetings and consultations with subordinates on crucial issues will stimulate employee morale and promote self-motivation as they will feel recognized and valued in the organization. This will be achieved through open and effective communication between the management and subordinates.

Humans as intuitive classifiers.

Mainstream decision research rests on two implicit working assumptions, inspired by subjective expected utility theory. The first assumes that the underlying processes can be separated into judgment and decision-making stages without affecting their outcomes. The second assumes that in properly run experiments, the presentation of a complete description of the incentive structure replaces the judgment stage (and eliminates the impact of past experiences that can only affect judgment). While these working assumptions seem reasonable and harmless, the current paper suggests that they impair the derivation of useful predictions. The negative effect of the separation assumption is clarified by the predicted impact of rare events. Studies that separate judgment from decision making document oversensitivity to rare events, but without the separation people exhibit the opposite bias. The negative effects of the assumed impact of description include masking the large and predictable effect of past experiences on the way people use descriptions. We propose that the cognitive processes that underlie decision making are more similar to machine learning classification algorithms than to a two-stage probability judgment and utility weighting process. Our analysis suggests that clear insights can be obtained even when the number of feasible classes is very large, and the effort to list the rules that best describe behavior in each class is of limited value.

On the robustness of indeterminacy in subjective probability

We examine the robustness of indeterminacy in subjective probability identified in Savage’s (1954) axiomatization of subjective expected utility theory. We show that this indeterminacy applies to betweenness conforming preferences, but does not extend to preferences without the betweenness property.

Differential effects of outcome and probability on risky decision

ABSTRACTDecision-making under uncertainty involves two main factors: probability and pay-off (outcome). Subjective expected utility theory argues that when making choices, the decision-maker selects the alternative that maximizes expected utility. Prospect theory argues that the decision-maker chooses the alternative that maximizes weighted value. Both theories argue for a weighted measure based on which the decision-maker makes choices. Neither explains, however, how probability and pay-off affect the decision-maker in making those choices. In addition, evidence exists that shows that utility is variable in relation to lotteries or frames, but how utility changes remains unknown. In this paper, we report an experiment to address this question; that is, how does pay-off or probability affect the decision-maker in making choices under uncertainty? The results show that when faced with gains, the decision-maker pays more attention to probability, whereas when faced with losses, the decision-maker seems equally sensitive to probability and pay-off in making choices under uncertainty.

Quantum Structures in Human Decision-Making: Towards Quantum Expected Utility

{\it Ellsberg thought experiments} and empirical confirmation of Ellsberg preferences pose serious challenges to {\it subjective expected utility theory} (SEUT). We have recently elaborated a quantum-theoretic framework for human decisions under uncertainty which satisfactorily copes with the Ellsberg paradox and other puzzles of SEUT. We apply here the quantum-theoretic framework to the {\it Ellsberg two-urn example}, showing that the paradox can be explained by assuming a state change of the conceptual entity that is the object of the decision ({\it decision-making}, or {\it DM}, {\it entity}) and representing subjective probabilities by quantum probabilities. We also model the empirical data we collected in a DM test on human participants within the theoretic framework above. The obtained results are relevant, as they provide a line to model real life, e.g., financial and medical, decisions that show the same empirical patterns as the two-urn experiment.

Neither Cognitive, Nor Consistency – A Comment on Cognitive Consistency Theory in Social Psychology: A Paradigm Reconsidered, by Kruglanski, et al.

In their article Cognitive Consistency Theory in Social Psychology: A Paradigm Reconsidered, Arie Kruglanski and colleagues effectively call for the retirement of the family of theories known as cognitive consistency theories, a move they characterize as a paradigm shift. We have deep reservations about the basic endeavor that underlies the target article. Seeking to supplant the CC paradigm with a model of affective reaction seems doomed to fail because affective arousal is inconsequential to the core essence and purpose of the family of CC theories. We are also unconvinced by the target article’s empirical critique. The manner in which the authors frame the CC paradigm seems to set it up for failure. The authors conceive of consistency in mechanical and narrow terms of information updating, they posit that any informational inconsistency should universally trigger a negative affective reaction, and imply that the arousal should overwhelm any other contemporaneous psychological state. We are also unimpressed by the Expectancy-Value Model proposed by the target article. The model’s linear and uni-directional flow robs it of the capability of capturing the bi-directional reasoning that lies at the core of structural dynamics, and which affords the ability to reconstruct the representation and restore the state of equilibrium. We also wonder about the novelty of the model in light of extant research on appraisal models of emotion, self-verification approaches, Subjective Expected Utility Theory, and even models of animal emotion. The authors of the target article would have us jettison the rich and impactful CCT in favor of a reductionist theory of affective reactions to good and bad news.

Why Teachers Assign Socially Unequal Marks. A Case for Establishing Tertiary Origin Effects in the Model of Primary and Secondary Effects of Educational Research

Subjective expected utility theory assumes that educational paths result from the interplay of primary effects – students’ cognitive skills – and secondary effects – academic decisions regarding their educational future. We argue that thus far, the assignment of marks has not been accounted for in the scope of Boudon’s model of primary and secondary effects. We propose an elaborated model in which psychological traits are included in the concept of primary effects and introduce a further component, tertiary effects, indicating teachers’ socially unequal assignment of marks. Empirically, we demonstrate that a specific psychological skill set has moderate influence on students’ marks, it does not, however, account for social inequalities in the assignment of marks. Nevertheless, our findings show that social differences in marks can almost entirely be explained by cognitive, psychological and resource-related tertiary effects. Furthermore, there is some evidence that the extent of tertiary effects is associated with the scholastic configuration of educational institutions. Lastly, we observe that teachers unknowingly overvalue children from higher social classes because they deem them more talented, more willing to achieve and better equipped with parental resources than children from lower social classes. A key question for future research is to find reasons for this biased perception. https://doi.org/10.26803/ijlter.17.7.1

Bounded rationality, ambiguity, and choice

This paper examines the hypothesis that cognitive limitations lead people to behave as if they are facing ambiguity, even when no ambiguity is apparent. We compare human subject decision behavior under total ambiguity, where no probability information is available, to behavior a case with no apparent ambiguity, where probabilities are transparently presented. We find that decision behavior in the Total Ambiguity case is predictive of the deviations we observe in the No Ambiguity case from the choice predictions of subjective expected utility theory. We also create prospect pairs to examine whether more cognitively challenging probabilities create ambiguity which we can identify using ambiguity theory. Using these pairs, we do not find evidence that a cognitively challenging probability creates ambiguity that systematically alters decision behavior.

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Measuring the Behavioural Component of the S&P 500 and its Relationship to Financial Stress and Aggregated Earnings Surprises

AbstractScholars in management and economics have shown increasing interest in isolating the behavioural dimension of market evolution. Indeed, by improving forecast accuracy and precision, this exercise would certainly help firms to anticipate economic fluctuations, thus leading to more profitable business and investment strategies. Yet, how to extract the behavioural component from real market data remains an open question. By using monthly data on the returns of the constituents of the S&P 500 index, we propose a Bayesian methodology to measure the extent to which market data conform to what is predicted by prospect theory (the behavioural perspective), relative to the (standard) subjective expected utility theory baseline. We document a significant behavioural component that reaches its peaks during recession periods and is correlated to measures of financial volatility, market sentiment and financial stress with expected sign. Moreover, the behavioural component decreases around macroeconomic corporate earnings news, while it reacts positively to the number of surprising announcements.

Testing ambiguity and Machina preferences within a quantum-theoretic framework for decision-making

The Machina thought experiments pose to major non-expected utility models challenges that are similar to those posed by the Ellsberg thought experiments to subjective expected utility theory (SEUT). We test human choices in the ‘Ellsberg three-color example’, confirming typical ambiguity aversion patterns, and the ‘Machina 50/51 and reflection examples’, partially confirming the preferences hypothesized by Machina. Then, we show that a quantum-theoretic framework for decision-making under uncertainty recently elaborated by some of us allows faithful modeling of the collected data. In the quantum-theoretic framework, subjective probabilities are represented by quantum probabilities, while quantum state transformations enable representations of ambiguity aversion and subjective attitudes toward it.

Information and Ambiguity: Toward a Foundation of Nonexpected Utility

The concept of ambiguity designates those situations where the information available to the decision maker is insufficient to form a probabilistic view of the world. Thus, it has provided the motivation for departing from the subjective expected utility (SEU) paradigm. Yet, the formalization of the concept is missing. This is a grave omission as it leaves nonexpected utility models hanging on shaky ground. In particular, it leaves unanswered basic questions such as the following: (1) Does ambiguity exist? (2) If so, which situations should be labeled as “ambiguous”? (3) Why should one depart from SEU in the presence of ambiguity? (4) If so, what kind of behavior should emerge in the presence of ambiguity? The present paper fills these gaps. Specifically, it identifies those information structures that are incompatible with SEU theory, and shows that their mathematical properties are the formal counterpart of the intuitive idea of insufficient information. These are used to give a formal definition of ambiguity and, consequently, to distinguish between ambiguous and unambiguous situations. Finally, the paper shows that behavior not conforming to SEU theory must emerge in correspondence of insufficient information and identifies the class of non-EU models that emerge in the face of ambiguity. The paper also proposes a new comparative definition of ambiguity, and discusses its relation with some of the existing literature.

Attitudes to Uncertainty in a Strategic Setting*

Much uncertainty in life relates to the behaviour of others in interactive environments. This article tests some implications of subjective expected utility theory (Savage, 1954) in an experimental strategic setting where there is uncertainty about the actions of other players. In this environment, a large majority of our participants violate subjective expected utility theory. However, they do not exhibit the sorts of consistent ‘attitude to ambiguity’ found in individual decision experiments. We discuss three possible explanations of their behaviour: non-linear transformation of probabilities; noise in responses; and/or systematic biases in the way that individuals generate subjective probabilities.

Bounded Rationality and Robust Mechanism Design: An Axiomatic Approach

We propose an axiomatic approach to study the superior performance of mechanisms with obviously dominant strategies to those with only dominant strategies. Guided by the psychological inability to reason state-by-state, we develop Obvious Preference as a weakening of Subjective Expected Utility Theory. We show that a strategy is an obviously dominant if and only if any Obvious Preference prefer it to any deviating strategy at any reachable information set. Applying the concept of Nash Equilibrium to Obvious Preference, we propose Obvious Nash Equilibrium to identify a set of mechanisms that are more robust than mechanisms with only Nash Equilibria.

A simple framework for the axiomatization of exponential and quasi-hyperbolic discounting

The main goal of this paper is to investigate which normative requirements, or axioms, lead to exponential and quasi-hyperbolic forms of discounting. Exponential discounting has a well-established axiomatic foundation originally developed by Koopmans (1960, 1972) and Koopmans et al. (1964) with subsequent contributions by several other authors, including Bleichrodt et al. (2008). The papers by Hayashi (2003) and Olea and Strzalecki (2014) axiomatize quasi-hyperbolic discounting. The main contribution of this paper is to provide an alternative foundation for exponential and quasi-hyperbolic discounting, with simple, transparent axioms and relatively straightforward proofs. Using techniques by Fishburn (1982) and Harvey (1986), we show that Anscombe and Aumann's (1963) version of Subjective Expected Utility theory can be readily adapted to axiomatize the aforementioned types of discounting, in both finite and infinite horizon settings.

From ambiguity aversion to a generalized expected utility. Modeling preferences in a quantum probabilistic framework

Ambiguity and ambiguity aversion have been widely studied in decision theory and economics both at a theoretical and an experimental level. After Ellsberg’s seminal studies challenging subjective expected utility theory (SEUT), several (mainly normative) approaches have been put forward to reproduce ambiguity aversion and Ellsberg-type preferences. However, Machina and other authors have pointed out some fundamental difficulties of these generalizations of SEUT to cope with some variants of Ellsberg’s thought experiments, which has recently been experimentally confirmed. Starting from our quantum modeling approach to human cognition, we develop here a general probabilistic framework to model human decisions under uncertainty. We show that our quantum theoretical model faithfully represents different sets of data collected on both the Ellsberg and the Machina paradox situations, and is flexible enough to describe different subjective attitudes with respect to ambiguity. Our approach opens the way toward a quantum-based generalization of expected utility theory (QEUT), where subjective probabilities depend on the state of the conceptual entity at play and its interaction with the decision-maker, while preferences between acts are determined by the maximization of this ‘state-dependent expected utility’.

On the Rejectability of the Subjective Expected Utility Theory

AbstractState space, a key element of the Subjective Expected Utility (SEU) theory, is not observable. This implies that, in order to test the SEU theory, it is necessary to assume some state space. Consequently, if the SEU theory is rejected, then it is appropriate to conduct a robustness check; that is, to search for a different state space and a probability over that state space which together do not lead to the rejection of the SEU theory. To find such state space and probability means to SEU-rationalize the agent’s behavior. I show how to conduct the process of SEU-rationalization and determine when an SEU-rationalization is possible.