Economic and Environmental Risk and Uncertainty: New Models and Methods PDF
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ECONOMIC AND ENVIRONMENTAL RISK AND UNCERTAINTY THEORY AND DECISION LIBRARY General Editors: W. Leinfellner (Vienna) and G. Eberlein (Munich) Series A: Philosophy and Methodology of the Social Sciences Series B: Mathematical and Statistical Methods Series C: Game Theory, Mathematical Programming and Operations Research Series D: System Theory, Knowledge Engineering and Problem Solving SERIES B: MATHEMATICAL AND STATISTICAL METHODS VOLUME 35 Editor: H. J. Skala (Paderborn); Assistant Editor: M. Kraft (Paderborn); Editorial Board: J. Aczel (Waterloo, Ont.), G. Bamberg (Augsburg), H. Drygas (Kassel), W. Eichhorn (Karlsruhe), P. Fishburn (Murray Hill, N.J.), D. Fraser (Toronto), W. Janko (Vienna), P. de Jong (Vancouver), T. Kariya (Tokyo), M. Machina (La Jolla, Calif.), A. Rapoport (Toronto), M. Richter (Kaiserslautern), B. K. Sinha (Cattonsville, Md.), D. A. Sprott (Waterloo, Ont.), P. Suppes (Stanford, Calif.), H. Theil (St. Augustine, Fla.), E. Trillas (Madrid), L. A. Zadeh (Berkeley, Calif.). Scope: The series focuses on the application of methods and ideas of logic, mathematics and statistics to the social sciences. In particular, formal treatment of social phenomena, the analysis of decision making, information theory and problems of inference will be central themes of this part of the library. Besides theoretical results, empirical investigations and the testing of theoretical models of real world problems will be subjects of interest. In addition to emphasizing interdisciplinary communication, the series will seek to support the rapid dissemination of recent results. The titles published in this series are listed at the end of this volume. ECONOMIC AND ENVIRONMENTAL RISK AND UNCERTAINTY New Models and Methods edited by ROBERTNAU Duke University, Fuqua School ofB usiness, Durham, North Carolina, U.SA. ERIKGR0NN Norwegian School ofM anagement, Department ofB usiness Economics, Sandvika, Norway MARK. MACHINA University of California at San Diego, Department ofE conomics, La lolla, California, U.S.A. and OLVA R BERGLAND Agricultural University ofN orway, Department ofE conomics and Social Sciences, Aas,Norway SPRINGER-SCIENCE+BUSINESS MEDIA, B.V. A C.I.P. Catalogue record for this book is available from the Library of Congress. ISBN 978-90-481-4849-3 ISBN 978-94-017-1360-3 (eBook) DOI 10.1007/978-94-017-1360-3 Printed on acid-free paper All Rights Reserved © 1997 Springer Science+Business Media Dordrecht Originally published by Kluwer Academic Publishers in 1997 No part of the material protected by this copyright notice may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording or by any information storage and retrieval system, without written permission from the copyright owner. Dedicated to the memory of OLE HAGEN 1921-1994 TABLE OF CONTENTS Preface ix Ole Hagen and the FUR Conferences FRED WENST0P xi L Models of Environmental Risk 1 Valuing Health and Safety: Some Economic and Psychological Issues MICHAEL J. JONES-LEE AND GRAHAM LOOMES 3 Improving Efficiency in Environmental Enforcement D. MARC KILGOUR 33 Valuation of Environmental Goods: Frame Effects in the Estimation of Multi-Criteria Utility Functions FRED WENST0P AND ARNE J. CARLSEN 53 Stochastic Trees and Medical Decision Making GORDONB. HAZEN AND JAYAVEL SOUNDERPANDIAN 65 Manipulation of Emission Permit Markets EIRIKROMSTAD AND OLVARBERGLAND 75 n. Risk and Uncertainty in Economic Theory 87 Allais Theory Offers Solution and Explanation for Equity Premium Puzzle JOHN GOLOB 89 Generalized Expected Utility and the Demand for Insurance: The Limits of Machina THOMAS RUSSELL 109 The Derivation of Generalized Expected Utility Expansions: Reply to Russell MARK MACHINA 115 Necessary Conditions for Efficient Multiple-Bid Auctions FRIEDEL BOLLE 123 Balanced Equilibrium: A Theory of Behavior in Games Based on Continuity and Insufficient Reason MARCO MARIOTTI 145 Mixed Extensions of Games and the St. Petersburg Paradox HANS HALLER 163 Consumption with Fluctuations in Preference KOm NAKAZAW A AND JOHN HEY 173 vii viii TABLE OF CONTENTS ill. Recent Progress in Modeling Preferences and Risk Attitudes 193 Dynamically Consistent Preferences, Quadratic Beliefs, and Choice Under Uncertainty JURGEN EICHBERGER AND SIMON GRANT 195 Induced Preferences and Decision Making Under Risk and Uncertainty DAVID KELSEY AND FRANK MILNE 207 On Socks, Ties, and Extended Outcomes HARRY MARKOWITZ 219 Hierarchies and the Self-Control of Risk Attitude LUC WATIllEU 227 Allais Phenomena and Completeness of Preferences S. ruos, s. ruOS-INSUA, D. ruOS-INSUA, J. PACHON, M.A. PACIOS, AND P. GARCiA BARRENO 245 Representing Preference Relations with Nontransitive Indifference by a Single Real- Valued Function GIANNI BOSI AND ROMANO ISLER 257 INDEX 263 PREFACE Since the early 1980's, the biannual international conferences on Foundations and Applications of Utility, Risk, and Decision Theory (the "FUR" conferences) have provided a forum in which much of the most innovative contemporary research on risk and uncertainty has been presented. This volume contains a selection of the best papers presented at the FUR VII conference, which was organized by the late Ole Hagen and held in Oslo from June 30 to July 3, 1994. The theme of the FUR VII conference was "Environmental Risk," which is reflected in the title and organization of the volume: Part I contains papers dealing with health and environmental applications of risk theory, including the plenary address given at the conference by Graham Loomes. Part II contains papers dealing with more general issues of risk and uncertainty in economic models of auctions, markets, and games. Part III contains papers which focus on the modeling of preferences and risk attitudes within individuals. As Professor Wenst0p observes in his memorial to Hagen on the following pages, the FUR conferences have chronicled an exciting period in the history of utility and risk theory, during which many revolutionary ideas have been proposed, debated, and applied to the study of economic institutions and individual decision-making. The papers in this volume continue that distinguished tradition. The editing of this volume has been a truly collaborative effort between Erik Gmnn (Norwegian School of Management), Mark Machina (University of California at San Diego), Olvar Bergland (Agricultural University of Norway), and myself. Special thanks are due to Erik Gmnn, who chaired the National Organizing Committee for the conference and who, at the last minute, also inherited the Program Chair's duties from Professor Hagen. He handled the difficult early work of collecting and organizing the many manscripts that were submitted for consideration in the volume, from which the papers presented here were later selected through a reviewing process that spanned four universities. The FUR VII conference was made possible through the generous financial support of the Norwegian School of Management and contributions from the Central Bank of Norway and the Norwegian Trade Council. Robert Nau Durham, North Carolina August 14, 1996 IX OLE HAGEN AND THE FUR CONFERENCES Volume 21 of the Theory and Decision Library, entitled Expected Utility and the Allais Paradox, was edited by Maurice Allais and Ole Hagen in 1979. Their intent was to initiate a debate concerning the foundations of risk and utility theory, and they were indeed successful. Volume 21 contained contributions by many distinguished authors, including Oskar Morgenstern, and addressed the conflict between what was then called the American School (Expected Utility Theory) and the French school (Allais' Positive Theory of Choice). That volume provided the inspiration for the FUR conferences. The idea was due to Werner Leinfellner, who was co-editor ofthe Theory and Decision Library. As a follow-up to the volume, he proposed that Ole Hagen arrange an international conference on the foundations of utility and risk theory. Hagen had performed several empirical studies demonstrating that people do not in fact behave according to the von Neumann-Morgenstern theory. To account for the observed behavior, he had in the years 1969-1972 developed an axiomatic theory of choice which generalizes the standard theory in that the third moment of the probability distribution over utilities is taken into account as well. The theory was certainly not welcomed in all quarters, but as it turned out to be similar to Allais', Hagen and Allais became allies in an endeavor to instigate an open debate. Leinfellner's encouragement was therefore a welcome opportunity for Hagen to create a forum where both proponents of new ideas and defenders of the established paradigm could participate. As a consequence, the first FUR conference took place at the Norwegian School of Management in Oslo in 1982. Hagen received enthusiastic local support during the preparations, notably at the University of Oslo where Bernt Stigum was instrumental. The conference attracted about 100 participants from around the world, and turned out to be a success by all standards. The debate turned decisively from whether new theories are at all required, to which ones are the most suitable under different conditions. By that time, there was mounting evidence from behavioral experiments about violations of the von Neumann-Morgenstern axioms--particularly the independence axiom. Several alternative axiomatic utility theories had recently been proposed to account for such behavior, and their authors were also present at the meeting. The contrasts among the new theories, the earlier theories of Allais and Hagen, and the standard theory of expected utility generated many exciting discussions. A revolution in "non-expected utility theory" had begun, and subsequent conferences in the FUR series would track the course of this revolution through the 1980's and into the 1990's. It is no secret that the early debate appeared more like a combat than an exchange of ideas between scientists. Hagen was no exception: he felt he had to pound very hard on the door of established science to make people listen and consequently developed a very personal, almost polemic writing style to achieve it. For Hagen, the first FUR conference turned out to be a personal triumph when his many years of opposition to the established theory were finally vindicated. He did not rest on his laurels, however, but participated with keen interest in the ensuing series of conferences in Venice (1994), xi
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