Epsilon Open Archive

Abstract

This study presents Preference Cloud Theory, a two-step model of decision making under risk. It also includes an experimental study on valuation gap which provides supporting results for the new theory. The new theory provides an explanation for empirically observed anomalies of Expected Utility Theory such as the Allais Paradox, valuation gap, and preference reversals. Central to the theory is the incorporation of preference imprecision, which has support in emerging literature, and challenges to the alternative models for Expected Utility Theory. Preference Cloud Theory assumes that preference imprecision arises because of individuals’ vague understanding of numerical probabilities. The theory combines this concept with the use of the Alpha Model (which builds on Hurwicz’s criterion) and constructs a simple model, helping us to understand various anomalies discovered in the experimental economics literature that standard models could not explain.