Market failure in light of non-expected utility

Eyal Baharad, Doron Kliger

Research output: Contribution to journalArticlepeer-review

Abstract

This paper merges the non-expected utility approach (Tversky and Kahneman, J Risk Uncertain 5:297-323, 1992 and Quiggin, J Econ Behav Organ 3:323-343, 1982) into Akerlof's (Quart J Econ 84:488-500, 1970) model of Market for Lemons. We derive the results for different probability weighting functions and analyze the phenomenon of market failure in light of non-expected utility maximization. Our main finding suggests that when the proportion of traded lemons is high (low), the problem of market failure is mitigated (enhanced). In addition, for the case of Cumulative Prospect Theory, we show that (a) the higher the loss aversion is, the more pronounced is the market failure; (b) gain-domain elevation is negatively related to the extent of market failure; and (c) the value function is (i) negatively monotonic in the gain-domain diminishing sensitivity parameter when the market is characterized by a high proportion of "peaches," and (ii) positively monotonic in the loss-domain diminishing sensitivity parameter when the market is characterized by a high proportion of "lemons."

Original languageEnglish
Pages (from-to)599-619
Number of pages21
JournalTheory and Decision
Volume75
Issue number4
DOIs
StatePublished - Oct 2013

Keywords

  • Decision analysis
  • Market for lemons
  • Prospect theory
  • Rank-dependent expected utility
  • Utility-preference

ASJC Scopus subject areas

  • General Decision Sciences
  • Developmental and Educational Psychology
  • Arts and Humanities (miscellaneous)
  • Applied Psychology
  • General Social Sciences
  • Economics, Econometrics and Finance (all)
  • Computer Science Applications

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