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

TL;DR

This paper develops a theory of expected utility with state-dependent linear utility functions that incorporate loss aversion, analyzing implications for stochastic dominance, risk preferences, and insurance contracts.

Contribution

It introduces a novel expected utility framework with state-dependent linear utility functions accounting for loss aversion, extending classical risk preference analysis.

Findings

Relates loss aversion to first order stochastic dominance

Connects mean-preserving spreads with linear utility profiles

Analyzes monopolist insurance contract offering with partial coverage

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.