Abstract
It is shown that von Neumann-Morgernstern (NM) expected utility maximization, as is currently practised, implies an upper bound on the percentage utility that can be sacrificed to reduce the probability or severity of a catastrophe. The major quantitative result of this paper is a simple tabular (and graphic) presentation of the maximum allowed “budget” for catastrophe prevention/abatement within the NM framework. The upper limit, which declines in proportion to catastrophe probability, effectively reduces the benefit-cost ratio for catastrophe protection. Use of formal utility maximization methods can thus result in the choice of policies that fail to avoid catastrophes that could be avoided at relatively low cost. Thus the decisions of risk-averse, risk-neutral, and risk-seeing utility maximizers tend to converge in catastrophe prone situations. The prospect theory of Kahneman and Tversky or the elasticity principle of Bernard offer more flexible options of risk aversion under these circumstances.
Similar content being viewed by others
References
Allais, M. and Hagan, O. (eds.): 1979, Expected Utility Hypothesis and the Allais Paradox, D. Reidel, Dordrecht, Holland.
Bernard, G.: 1984, ‘On Utility Functions: the Present State’, Theory and Decision 17, 97–100.
Friedman, M.: 1962, Capitalism and Freedom, University of Chicago Press, Chicago.
Kahneman, D. and Tversky, A.: 1979, ‘Prospect Theory: an Analysis of Decision Under Risk’, Econometrica 47(2), 263–291.
Karmarkar, U. S.: 1974, ‘The Effect of Probabilities on the Subjective Evaluation of Lotteries’, MIT Working Paper No: 698–74, Sloan School of Management, MIT Cambridge, MA.
Karmarkar, U. S.: 1978, ‘Subjectively Weighted Utility: a Descriptive Extension of the Expected Utility Model’, Organizational Behavior and Human Performance 21(1), 61–72.
Von Neumann, J. and Morgenstern, O.: 1947, Theory of Games and Economic Behavior, Princeton University Press, Princeton, New Jersey.
Schoemaker, P. J. H.: 1980, Experiments on Decisions Under Risk: the Expected Utility Hypothesis, Nijhoff, Boston, MA.
Schoemaker, P. J. H.: 1982, ‘The Expected Utility Model: its Variants, Purposes, Evidence and Limitations’, Journal of Economic Literature XX, 529–563.
Stigler, G. J.: 1975, The Citizen and the State, University of Chicago Press.
Author information
Authors and Affiliations
Additional information
Professor of Engineering and Public Policy, Carnegie-Mellon University, Pittsburgh.
PhD candidate in Engineering and Public Policy, Carnegie-Mellon University, Pittsburgh and Assistant Professor, College of Business Administration, University of Nevada, Reno.
Rights and permissions
About this article
Cite this article
Ayres, R.U., Sandilya, M.S. Catastrophe avoidance and risk aversion: Implications of formal utility maximization. Theor Decis 20, 63–78 (1986). https://doi.org/10.1007/BF00133637
Issue Date:
DOI: https://doi.org/10.1007/BF00133637