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.