Loss Aversion and State-Dependent Linear Utility Functions for Monetary Returns

Abstract

We present a theory of expected utility with state-dependent linear utility functions for monetary returns, that incorporates the possibility of loss-aversion. Our results relate to first order stochastic dominance, mean-preserving spread, increasing-concave linear utility profiles and risk aversion. As an application of the expected utility theory developed here, we analyze the contract that a monopolist would offer in an insurance market that allowed for partial coverage of loss.

arXiv comment13 pages. Linearity for gains and linearity for losses are compatible with loss aversion. Ambiguity and aversion for it can be accommodated in our framework