ABSTRACT
Within the framework of risk based engineering decision making one is often faced with the problem of integrating risk perception into the formulation of the utility function. Often it is felt that the standard linear utility function is inappropriate as it fails to express the increasing undesirability of large consequences. In practical risk assessment various proposals for non-linear utility functions have been suggested and applied. But the question remains which type of nonlinear utility function would be appropriate in a given situation and whether it would lead to a rational decision.
The basic premise of this paper is that the risk aversion described by non-linear utility functions can almost always be explained by the non-inclusion of certain “follow-up” consequences. “Follow-up” consequences are, generally speaking, triggered by extreme losses, such as excessive business losses, loss of reputation or other indirect or so-called intangible losses. The non-inclusion of such losses occurs either voluntarily or involuntarily. Although in principle the use of appropriate nonlinear utility functions and the inclusion of”follow-up” consequences are mathematically equivalent and may lead to identical decisions, only the latter approach leads to risk-consistent rational decision making. An illustrative example is given in the paper, highlighting the significance of the findings.
