Foundations of Risk Measurement. I.

Risk As Probable Loss

Author(s): Peter C. Fishburn
Source: Management Science, Vol. 30, No. 4, Risk Analysis (Apr., 1984), pp. 396-406
Published by: INFORMS
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MANAGEMENT SCIENCE
Vol. 30, No. 4, April 1984
Printed in U.S.A.

FOUNDATIONS OF RISK MEASUREMENT.

I. RISK AS PROBABLE LOSS*
PETER C. FISHBURN

Bell TelephoneLaboratories,Inc., Murray Hill, New Jersey 07974

This paper seeks to get behind specific contextual referents of risky situations to consider
characteristics of risk that apply to many situations. It is guided by previous theoretical and
empirical research in perceived risk, and focuses on the joint effects on risk of loss probability
and the distribution of losses. The approach taken follows modern axiomatic theory by
proposing conditions on a relation "is at least as risky as" between pairs of probability
distributions over an outcome variable. Several sets of axioms for risk that characterize
different forms for risk measurement are presented.
(RISK MEASUREMENT; PROBABILITY OF LOSS)

1. Introduction
Conventional wisdom in medicine, insurance, safety, strategic planning, personal
relations, diplomacy, banking, and other fields says that risk is a chance of something
bad happening (Krewski and Brown 1981, Ricci and Molton 1981, Slovic et al. 1981).
Although numerous context-specific measures of risk have been proposed, my aim
here is to go behind specific contextual referents and to explore risk measurement from
an axiomatic perspective. The study will be guided by three things, namely previous
theoretical work on axiomatic models of risk and preference, empirical studies of
perceived risk, and the conventional notion that risk arises from a possibility of
undesirable outcomes.
It will be presumed that outcomes can be preferentially ordered and assigned
numerical values that preserve the preference ordering. It is assumed further that a
'target' outcome can be identified so that every outcome whose value is smaller than
the value of the target is viewed as 'undesirable' or 'risky', while outcomes with values
as large as the target's are nonrisky. Depending on context, risky outcomes may
involve rates of heart disease or accidents, loss of life, loss of face, defaults on loans,
and loss of capital. For convenience, the value of the target outcome will be set at zero.
Values of outcomes will often correspond to a natural index (lives lost, dollar gains),
and the zero value may have a natural interpretation (0 lives lost, no loss-no gain
point).
The axioms for risk measurement will be based on a binary relation -, "is at least
as risky as," defined on a set of probability distributions over outcome values. The
distributions can be viewed as hypothetical; the ubiquitous and often knotty problem
of estimating probabilities for actual decision alternatives will not be considered here.
The asymmetric and symmetric parts of ? will be denoted >- ("is riskier than") and
- ("is equally risky as").
The preceding formulation implies that, apart from targets and probabilities, the
only risk-relevant aspect of outcomes is their relative preferences. I assume in effect
that risk makes no distinction among equally-valued outcomes. Other commitments
that apply throughout the study include (i) ? is a weak order (complete, transitive),
(ii) the risks of probability distributions over outcome values are numbers that preserve
X, (iii) the numerical measure of risk is nonnegative, and (iv) a distribution has zero
risk if and only if it has no chance of producing a bad outcome.
*Accepted by Rakesh K. Sarin, Special Editor.
396
0025- 1909/84/3004/0396$O1 1.25
Copyright (C 1984, The Institute of Management Sciences

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RISK AS PROBABLE LOSS

397

The present paper concentrates on distributions that assign probability 1 to values

less than or equal to 0, the target value. Distributions admitting favorable as well as
undesirable outcomes will be considered in a sequel (Fishburn 1982). The numerical
measure of risk used here is denoted as p. The forms of p to be axiomatized are
outlined at the end of the next section.
A word about preference, uncertainty and risk as they apply to the present study
seems advisable in light of semantic confusion about "risk"in the literature of decision
theory (Arrow 1965, Coombs 1974, Hertz 1964, Luce and Raiffa 1957, Markowitz
1959, Pratt 1964). I use preference in the traditional mode (Chipman et al. 1971,
Fishburn 1970, Krantz et al. 1971). Uncertaintyrefers to probabilities strictly between 0
and 1, and to distributions with such probabilities, or to decision alternatives with
several possible outcome values. Risk is intended in a conventional manner. It is based
in part on outcome preferences and targets. I generally assume that risk increases as
bad outcomes become more probable, and as probable bad outcomes get worse. While
favorable outcomes are not associated with risk by themselves, their presence in a
distribution that has positive probability for bad outcomes might decrease the risk of
the distribution. This will be discussed further in Fishburn (1982).
Uncertainty is not taken as an inherent part of risk. In the present conceptualization,
a distribution with a large variance but probability 1 over favorable outcomes has no
risk, while a sure-thing distribution with probability 1 of $10,000 loss is regarded as
risky.
Finally, although preferences between probability distributions are presumably
associated with the distributions' risks in ways that go beyond our bare connection
with outcome preferences, I shall not speculate on such associations in this study. A
discussion that touches on this point is provided by Schaefer (1978): also see (Fishburn
1977, Libby and Fishburn 1977, Payne et al. 1981).
2.

Notations and Definitions

Outcomes are assumed ordered by preference and represented numerically so that

one outcome is preferred to another if and only if the former has a larger value
(Fishburn 1970, Krantz et al. 1971). Let X denote the set of outcome values. By
convention, a designated nonrisky target outcome has value 0. Nonzero outcome
values are partitioned into unfavorable and favorable subsets as
X- = {x E X: x < 0} and X+ = {x E X: x > 0}.
I shall refer to outcome values simply as outcomes, to outcomes in X - as losses, and to
outcomes in X + as gains. It is assumed that X - is not empty. If lives lost is the sole
concern, X - = - 1, -2, . . ., - N) and X+ = 0. A monetary context could have
X - = (-oo,0) and X + = (0,oo).
Probability measures are defined on a Borel algebra of subsets of X that includes
singleton subsets and 'intervals' of outcomes, and are assumed to be countably
additive (Fishburn 1970, 1975). We let P - denote a set of probability measures with
p(X - ) = 1 for each p E P -, so that each such p is certain to result in a loss. In the
sequel I shall assume also that X + is not empty and incorporate a second set P + of
probability measures that are certain to yield gains. Combinations of measures in Pand P + will then be used to characterize probability measures over X.
All relevant one-point measures on outcomes in X - are assumed to be in P -, which
is taken as closed under convex combinations. Thus Xp + (1 - X)p' E P- when
p, p' E P - and 0 < X < 1. Integration is Lebesgue-Stieltjes integration.
Experiments with monetary gambles have convincingly demonstrated the salience of
loss probability and amount on perceived risk (Aschenbrenner 1978, Coombs and
Lehner 1981, Payne 1975, Slovic 1967). Moreover, preference attitudes toward gambles

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398

PETER C. FISHBURN

in the loss and gain regions exhibit striking differences (Fishburn and Kochenberger
1979, Hershey et al. 1981, Kahneman and Tversky 1979, Laughhunn et al. 1980, Payne
et al. 1980, 1981). These observations, coupled with the usual conception of risk,
suggest a formulation for risk in the P - context that takes explicit account of loss
probability as well as the distribution of losses. Accordingly, I shall apply > to
A = [0, 1] X P - = {(a, p) :0 < a < l,p E P - },
where (a, p) is interpreted as a measure that yields an x E Y for Y C X - with
probability ap(Y), and gives outcome 0 with probability 1 - a. The probability of loss
is a and, given a loss, p(Y) is the probability that the loss will be in Y.
I shall sometimes abbreviate (1, p) as p, (0, p) as 0, and (a, p) as (a, x) when
p({x}) = 1. By interpretation, (0, p) = (O,q) = 0 for allp,q E P. In addition, (1,x) is
sometimes written simply as x.
Set A applies when X + is empty, or when X + is not empty and gains have the same
effect on risk as outcome 0. Numerical risk measures p that represent > on A will
adhere to the following:
0 if
DEFINITION. p is a nonnegative real valued function on A that has p(a, p)
and only if a = 0. When p({x}) = 1, p(a, p) is also written as p(a,x).
The basic risk representation for A has
(a, p) : (a', p'))p(a,

p) > p(a', p').

(1)

I then discuss axioms for : on A that yield the following special forms of p:
p(a, p) = pj(a)P2(^
p(a, p) =

_p(a, x) dp(x),

p(a)_P2(x)dp(x),

p(a, p)

p(a, p) = a p2(x) dp(x),

p(ap)

P1(a)f

xI'dp(x),

9 > 0.

The first form posits separability between total loss probability and the distribution of
losses, so that a and p act as independent factors whose measurements combine
multiplicatively in the overall measurement of risk. The second form, which is logically
independent of the first, says that for each a, risk can be written in expected-value
form for the various measures in P -.
The third form essentially combines the first two in a separable-expectations model.
While Pi is increasing in a with Pj(0) = 0, this form allows Pi to be nonlinear in the loss
probability a. Linearity in a appears in the fourth form, which is tantamount to
Huang's (1971) expected-risk model for A.
The final form specializes the third form in a different way by taking p2(x) as the
power function lxl with parameter 9 > 0. When pl(a) = a,
p(a,p)=

I
xIdp(x).

This form is used in a mean-risk analysis by Fishburn (1977) and has been axiomatized by Luce (1981). When 9 = 2, it gives Markowitz's (1959) below-target semivariance risk measure; when 9 = 1, we get the weighted-losses measure of Domar and
Musgrave (1944). These risk measures are palatable only when outcomes have a
natural meaning (accidents per month, dollars lost).
Parameter 9 reflects judgments of the risks incurred by losses of different magni-

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RISK AS PROBABLE LOSS

399

tudes. If risk escalates rapidly as losses increase, 9 > 1. If the likelihood of loss is
paramount without special regard for magnitude, 9 < 1. At 9 = 0, risk is simply the
probability of loss.
3.

Basic Axioms and Separability

Five axioms are used for the basic representation (1). They apply to all a, /3, y E
[0,1], all x, y E X-, and allp,q E P.
Al. > on A is a weak order;
A2. If a > / then (a, p) >-( /3,p);
A3. If x <y then x >-y;
A4. If (a, p) >- (,8, q) >- (yp ), then (Xa + (1 - X)y, p)-(/3, q) for some 0 < X < 1;
A5. w :p for some w E X -.
Axiom A2 says that risk increases as the loss probability increases (p fixed), and A3
says that worse outcomes entail greater risk. A4 is a continuity condition in which X is
unique according to Al and A2. The fifth axiom says that for every measure in P -,
some outcome is at least as risky as the measure. This seems sensible if there is a worst
outcome, but might be less obvious if outcomes are unbounded below.
THEOREM 1. Axioms Al throughA5 imply that there is a p on A that satisfies (1) for
all (a, p), (a', p') E A and is continuousand increasing in a.
PROOF. The proof when X - has a worst outcome is subsumed under the following
analysis. Suppose X - has no worst outcome. Let wI, w2, ... be a decreasing sequence
of outcomes in X - such that, for all x E X -, wk < x for some k. By A2, A3 and A5,
every (a, p) E A has some wk :(a, p).
Construct p on [0, 1] x {wIw2, .... 4 as follows. Let p(a, w1) = a. By Al and A2, (1)
holds at w1 with p continuously increasing in a and p(O)= 0. Take w2 next. By AI-A4,
there is a unique X2 at which (X2,w2)-wW, and for every a E [0, X2] there is a unique
f(a) where (a, w2)-(f(a), wI). It is easily checked thatf is continuous and increasing in
a with f(O) = 0 and f(X2) = 1. To satisfy (1), set p(a, w2) equal to f(a) for 0 < a < X2.
For a > X2 take p(a,,w2) = 1 + (a - X2)/(1 - X2). Then (1) holds on [0, 1] x {w,w2)
with p(-, w2) continuously increasing in a and p(l, w2) = 2. Next, W3 is traded off
against w2 in a similar manner, extending p to [0, 1] x {WI, W2, W34 with p(l, w3) = 3.
The process continues through the Wk.
Suppose p X {ww2, .. . 4. Take wk-p, and, by Al-A4, let g(a) be the unique
The axioms imply that g is continuous and
number at which (a,p)-(g(a),wk).
increasing with g(O) = 0 and g(l) < 1. To satisfy (1), take p(a, p) = p(g(a),wk). Since g
is continuously increasing in a, and p( I,wk) is continuously increasing in g, p(-, p) is
continuously increasing in a. This is done for each such p. It follows from Al that (1)
holds everywhere. Q.E.D.
Three more axioms are used for a - p separability. They apply to all a, /3,y E [0, 1]
and allp,q,r E P-.
A6. If (a, p) >- (3, q) >- (a, r), then (a, Xp+ (I -X)r) - (/3, q) for some 0 < X < 1;
A7. If a, 3 >0, then (a,p) (a,q) implies (/P,p) (/P,q);
A8. If (a, p)- ( /3, q) and (/,, r)>-(y, p), then (a, r)- (y, q).
Axiom A6 is a continuity axiom for the p component: if (/3, q) is riskier than (a, r)
but less risky than (a, p), then it is equally risky as some convex combination of (a, r)
and (a, p). Independence condition A7 says that the risk order on P - is the same for
each positive a. This is necessary for separability, but we also need Thomsen's
condition (Krantz et al. 1971), A8, which seems less obvious for risk than preceding
axioms. Its necessity for separability when a, /, y > 0 follows directly from the
separable form p = P1P2*Its plausibility for risk may be debatable.

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PETER C. FISHBURN

400

THEOREM2. Axioms A1-A8 imply that there are real valued functions pI on [0, 1]
and P2 on P - such that (1) holds for all (a, p), (a', p') E A when p(a, p) = pI(a)PAA
with:
(i) Pi continuousand increasing in a;
(ii) PI(O) = 0;
(iii) P2(P ) an interval of positive numbers;
(iV) p2(X) increasing as x decreases.
Moreover, if X - contains two or more outcomes, then Pi and P2 are unique up to similar
power transformations,i.e., p' and p'2also satisfy the representationif and only if there
are positive numbersa, al and a2 such that p' = a pa and p'2= a2p .
PROOF. Let p satisfy Theorem 1 and, to avoid the trivial case, assume that
I > 2. Then, using A2 and A6, and with h(p) = p(l, p), h(P - ) is a nondegenerate

IX -

interval

of positive

(a, h(p)) and apply

numbers.

A6 will not be used further.

Using

A7, represent

(a, p) by

? to (0, 1] X h(P - ), with risk strictly increasing in each compo-

nent. Standard theory for conjoint measurement,

e.g. (Fishburn
(Krantz et al. 1971, Chapter 6), implies that there are real valued
and r2 on h(P -) such that, with r2(p) = r2(h(p)),

(a, p)

(I3,q)i=rI(a)

1970, pp. 65-71) or

functions r, on (0, 1]

+ r2(p) > r (/3) + r2(q)

whenever
a, /8 > 0. In this additive form, rl((0, 1]) and r2(P - ) are nondegenerate
intervals, the two functions
are unique up to simultaneous
affine transformations
of
the form {r' = ar, + bl, r' = ar2 + b2, a > 0), and it follows easily from A4, A7, and
- co as a ->0. With p (a)= eri(a)
other axioms, that r (a) approaches
and P2(P)
= er2(P), we get (a, p) (/3,q) if and only if p1(a)P2(P) > pI(3)p2(q),
a, / > 0, with PI
and P2 having properties (i) through (iv) of the theorem when PI is extended to 0 by
taking Pl(O) = 0. The uniqueness
part of Theorem 2 follows from that for r, and r2.
Q.E.D.
4.

Linear Forms for A

This section axiomatizes

three special p forms that are based on linearity and
conditions
used in utility theory (Fishburn
independence
1970, Herstein and Milnor
1953, Keeney and Raiffa 1976). The first form is linear in p, i.e.,

p(a,Xp + (1 - X)q)

Xp(a,p)

+ (1 - X)p(a,q),

but it does not presume separability between a andp as in Theorem 2. The second and
third forms entail separability.
One technical point that is relevant only when P - contains nonsimple
measures
In addition
(pr. < 1 on every finite subset of X -) requires attention.
to earlier
on P - (one-point
conditions
convex closure), I shall assume that P - is
measures,
on intervals. If Y is an interval in (- xo, 0) and p( Y n x - )
closed under conditioning
> 0, let py be defined by py(Z) = p( Y n Z)/p( Y n x - ) for all Z in the algebra.
When p E P -, I assume that all such py are also in P -.
or expectation
Special axioms are needed for integrability,
forms, when P - contains
measures. Since these are redundant
when P - has only simple measures,
nonsimple
they will be denoted as Cl, C2, and so on to distinguish them from the other axioms.

Nonseparable Expectation
I shall axiomatize
p(a, p) = fp(a, x) dp(x) in three steps. The first deals with each
a > 0 separately.
The following
axioms apply to all a, X e (0, 1], all p, q, r E P -, all
simple (pr. 1 on some finite subset of X ) s E P -, all Y C X - in the algebra, and all
xE X-.

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401

RISK AS PROBABLE LOSS

A9. If (a,p)>-(a,q), then (a,Xp+(1 -X)r)>-(a,Xq+(1

-X)r);
C1. If p ( Y) = 1, then (a, p) ? (a, x) if (a, y) : (a, x) for all y E Y, and (a, x) > (a, p)
if (a, x) :(a, y) for all y E Y;
C2. If (a, p) >- (a,s) then (a, p[Yo)) (a,s) for some y E X-; if (a,s) >- (a, p) then
(a, s) 7(a, p( - ? ) for some y E X -.
Axiom A9 is a typical linearity-independence axiom that is essential for the linear
form
fa(p + ( -X)q) = Xfa(p) + (1 -X)fa(q)
implicit in Lemma 1. The special conditions Cl and C2 are used to extend this to
fa (P) = ffa (x) dp(x) when p is nonsimple. Cl is a reasonable dominance axiom, and
C2 is a truncation-continuity axiom.
1. Axioms Al, A3, A6, A9, Cl and C2 imply that for each aE (O,1] there is
LEMMA
a real valuedfunction fa on X - such that fx -fa (x) dp(x) is well defined and finite for
everyp E P- and, for all p,q E&P

(ap

<JXfa (x) dp(x)

(,q)

> Jfa (x) dq (x)

Moreover,fa is unique up to positive affine transformationsfa = afa

b (a > 0).

PROOF. See Theorem 3 in Fishburn (1975). Q.E.D.

The second step towards fp(a, x) dp(x) aligns the fa so that an expression like (1)
holds on (0, 1] x P -. The following apply to all a, /3, y E (0, 1] and all p, q, r, s E P -.
AO0. If (a, p)-( /3,r) and (a, q)-( /3,s), then (a, yp + (1 - y)q)-( /3, yr + (1 -)s);
All. If ao< I then there exist n>2, a =a1< a2< ... < an= I and pi,qiEP
such that (ai, pi)>- (ai+ 1,qi) for i = 1, . . , n -1.
Axiom A10, which is necessary for the form in Lemma 2, says that equally risky a
and /8 comparisons remain equally risky under similar convex combinations in their
second components. The second new axiom is a version of standard-sequence axiom
(Krantz et al. 1971) that ensures overlaps in risk for different a.
2. Axioms Al-A3, A6, A9-AI 1, Cl and C2 imply that there is a real valued
LEMMA
function f on (0, l]>< X - such that fx-f(a, x) dp(x) is well defined and finite for all
(a, p) E A\{O} and, for all (a, p),(13,q) E A\{O),
_f( a,x)dp(x)

(a, p)i(83, q)j

>

f(8/3,x)dq(x).

Moreover,f is unique up to positive affine transformations(af + b, a > 0).

PROOF. Let the fa be as specified in Lemma 1, and let fa(p) = ffa (x) dp(x). Set
< 1: minimum n for a in All is m). We work with E2

f(l, p) = f1(p). Let Em = {0 < a

first. Given a E E2, let

P(a) = {p E P

for some q E P}.

(a, p):(I,q)

It is easily seen that P(a) is closed under convex combinations and, for every
p E P(a), there is q E P - such that (a, p)-(l, q). Given the latter- statement, set
f(a, p) equal to f(l, q). Suppose (a, p)>(l, q) and (a, p')>(l, q'). Then, by A10,
(a, yp + (1-y)p')-(l,

yq + (1
f(a,yp

y)q'). Therefore

+ (1 - y)p') =f(l,yq

+ (1

y)q')

= yf(l,q)

+ (1 - y)f(l,q')

yf(l,

p) + (1 - y)f(a,
pI),

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PETER C. FISHBURN

402

q)<>fa(p) )fa(q) on
sof(la, ) is linear on P (a). Since f(a,p) )f(la, q)(a,p)>(a,
P(a), f(a,.) must be a positive affine transformation of fa(.) on P(a), say f(a,.)
a(a)fa ) + b(a). Extend to all of P - by settingf(la, p) = a(a)fa(p) + b(a).
Suppose a, 8 E E2, a #/3 8, and (a, p)>(/3,q) but (1,r) >- (a, ) for all r E P.
Pi) (3,qi)
Then pi and qi can be chosen so that Pi, P2 E P (a), q1,q2 E P(3)a,
(a, P2)-( /3,q2), (a, Pl) >- (a, P2) >- (a, p) and (/3, qj) >- (/3, q2) >- (/,, q). By A6 and
AlO, get y E (0, 1) with
-

(a, P2)-(a, yp1 + (1 - y)p)'8( /3,yql + (1

y)q)-(

/, q2).

By linearity and Lemma 1,

f(a, P2) = yf(a, Pi) + (1 - y)f(a, p),
f(/3,q2) = -yf(/3,qi) + (1 -

f(,q),

and, since f(a, pi) = f( /3,qi) for i = 1, 2, it follows that f(a, p) = f( 3, q). Because of the
order and continuity axioms, it then follows that the representation of Lemma 2 holds
on ({1} U E2) x P- whenf(la,x) = a(a)fa(x) + b(a) on X-. Moreover,f as thus far
constructed is unique up to a positive affine transformation since this is true of f(l, .).
If E3 is not empty, the next step integrates the a E&E3 into the representation by
suitable positive affine transformations of the fa. The process continues through all
nonempty Em. Details will be omitted. Q.E.D.
Lemma 2 leads to p(a, p) = fp(a, x) dp(x) with p(O)= 0 if f is bounded below, but
examples show that its axioms do not imply lower boundedness (even when X - has a
maximum). The third step therefore requires conditions that bound f below. This can
be done in various ways, but I shall identify only one here.
A12. There are 8 E (0, 1) and p E P - such thatfor every a E&(0, 1] there is a pa E P for which (a, p + (I - 8)t) > (1, pa) for every t E P -.
This is a uniform boundedness condition that is substantially stronger than All
since it implies that A 1I always holds for n = 2. It is most plausible if sup X - = 0, for
then pa can be chosen as xa near 0. However, Al12 can hold when X - is bounded away
from 0, as will be shown in the next subsection.
THEOREM3. The axioms of Lemma 2 with All replaced by A 12 imply that there is a
real valuedfunction p on [0, 1] X X - such that p(O,x) = 0, fp(a, x) dp(x) is well defined
and positive for all (a, p) E A \ {O} and, for all (a, p), (/3, q) E A,

(a, p) >:(/,8q) <=

p(a x) dp(x) > Jxp(/,8,x) dq(x).

Moreover,we can require inf p((O,1] X X

similarity transformations(ap, a > 0).

) =

0 and, when this is true, p is unique up to

PROOF. Let f be specified by Lemma 2, and fix 8, p and the Pa as assured by A1 2.

For a = 1, (1,3p + ( - 8)t) >- (1,p) gives

f(,t)>

f(l, PI)-

f(l, p)

for all t E P

where f(a, q) = ff(a, x) dq(x). Hence f(l, *) is bounded below, say f(l, t) > K for all
t E P-. For a < I get
f(a, t)> f(l, pa)3-f(a,
Since f(l, pox)> K, and -f(a,
f(at,t) >(K-

p)

for all t E P.

p) > -f(l, p) by A2 and Lemma 2,

3f(l, p))/(l 1-3)

for every 0 < af K 1 and every t E P-.

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403

RISK AS PROBABLE LOSS

Hence f is bounded below. Since f decreases as a decreases for fixed x or p, it has no

minimum so, by adding an appropriate constant to f to get p we have inf p((O,1] X
X - ) = 0 with p(a, x) > 0 whenever a > 0. Setting p(O,x) = 0, Theorem 3 then follows
from Lemma 2. Q.E.D.
Separable Expectation
on P - is the same for each a > 0-is now added to the analysis of
Axiom A7the preceding subsection. In the context of Lemma 2, A7 implies (Fishburn 1970,
Theorem 8.4) that there are real valued functions f1 and g1 on (0, 1] with f1(l) = 1,
gl(l) = 0 and fi > 0 such that, with f2(x) = f(l, x),
f(a, x) = f1(a) f2(x) + gI (a)

x X.

for all (a, x) E(0, 1]

In the context of Theorem 3, with p2(x) = p(l, x), we get

x X,

for all (a, x) E (0, 1]

p(a, x) = pI(a)p2(x) + a1(a)

where pI(1) = 1, aI(1) = 0 and PI > 0. Moreover, to have p(0,x) = 0, we need PI(O)
= a1(0) = 0. If a
0, this gives the form p(a, p) = pI(a)fp2(x)dp(x) mentioned earlier.
However, the axioms of Theorem 3 plus A7 do not imply a _ 0. For example, if
P2(P - ) = [1, 4], p (a) = (a + 1)/2 and a1(a) = (a - 1)/2 for a > 0, then
= [(a + 1)fp2(x)dp(x)

p(ap) =J p(ax)dp(x)

+ a

(a > 0)

1]/2

along with p(O)= 0 implies A7 and all axioms of Theorem 3, including A12, when we
take ? defined by
q) -*p(a, p) >, p(,8q)

(a, p)

Moreover, since min{p(a, p): p E P - } = a for each a > 0, inf p((0, 1] X X -) = 0.

0.
On the other hand, if P2 approaches 0 as x increases towards sup X -, then a
The following companion of A12 suffices for this.
A13. If (a, x) E (0, 1] x X -, then (a, x) >- (1, y) for some y E X.
4. Axioms A1-A3, A6, A7, A9, A10, A12, A13, Cl, and C2 imply that
THEOREM
there are real valuedfunctions PI on [0, 1] and P2 on X - such that, for all (a, p), (/3, q)
EA,
(a, p) (3q),>

XpI (at)

dp(x) > plI

_PO)

P2(x)

dq(x),

with pl(1)= 1, pi(0)= 0, Pi increasing in a, P2 positive and decreasing in x, and

inf p2(X- ) =0. Given these aspects of PI and P2' PI is unique and P2 is unique up to
similarity transformations.
PROOF. Begin with p of Theorem 3, including inf p((O,1] X X)
and aI as before:
p(a,x)

= pI (a)p2(X)

Pi(l)

1,

+ a1(a),

Pi()

P2(x)

= a(')

0. Define Pi, P2

p(1,X),

= a1(0) =0.

By A13, pI(a)P2(X)+ a1(a) > P2(Y) for some y, given a > 0 and x. Let inf P2(Y)= K
> 0. Then pl(a)K + a1(a) > K for all a > 0, hence 0 > K, hence K = 0. Thus a1(a)
> 0 for

all

a > 0. If a1(a) > 0, p2(x)

near

0 gives

pl(a)p2(x)

+ a1(a)

> p2(x),

or

(a,x) >- (1,x), contrary to A2. Therefore a1((a)= 0 for all a. The rest of Theorem 4
follows readily from A2, A3 and the uniqueness part of Theorem 3. Q.E.D.

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PETER C. FISHBURN

404

Linearity in Loss Probability

The following strengthenings of A6 and A9, applied to all A E (0, 1] and p *, q*, r*
E A, will be used to get p (a) = a. One can view p*, and so forth, as measures with
probability 1 on X- U {0}.
A6*. If p* > q* > r* then Ap* + (1-A)r*,q*
for some 0 < A < 1;
A9*. If p*

>

q* then ,p* + (1 - ,)r*

>

puq*+ (1

)r*.

New versions of CI and C2 are also needed. The following apply to all p* E A, all
simple s* E A, all Y c X- U {0} in the algebra, and all x E X- U {0}.
C1*. If p*(Y) = 1, thenp* >x ify x for ally E Y, and x cp* if x y for ally E Y;
C2*. If p* > s* then p[*O]> s* for some y E X - U {0}.
The conclusions of the next theorem follow readily from Theorem 3 in Fishburn
(1975) when p* E A is written as ap + (1 - a)O, where 1 - a = p*({0}) and p =
p(-_O)*

The form for p is tantamount to Assumption 3 in Luce (1981).

THEOREM5. Axioms A1-A3, A6*, A9*, C1* and C2* imply that there is a
nonnegative, decreasing function P2 on X - U {0} with P2(O)= 0 such that, for all
(a, p),(1, q) e A,
(a, p)> (/3, q) < af

P2(X)

dp(x) >

fP2(x

dq(x),

and P2 which satisfies this is unique up to similarity transformations.

5.

A Power Function for A

For analytical simplicity, the power form p2(x) = Ix19 is considered only when
X --(-so,

0), and then within the context of Theorem 4, where p2(x) approaches 0

as x approaches 0 from below. One can axiomatize the power form for the setting of
Theorem 5 in a slightly simpler way, but what I do here will suffice for Theorem 5.
A new axiom, patterned after Luce (1981), is based on scale changes in outcomes.
For simple p E P -, let p(X) be the simple measure in P - whose point probabilities are
defined by
p(X)(x) = p(Xx)

for all x E X

(X > 0).

1 or -5, thenp(2) is an even-chance

gamble for -2 or - 10.
5/2,
The following applies to all simple p, q E P - and all X > 0.
A14. If p.- q then p(X) , q(X).
This says that , is preserved under uniform rescaling of outcomes. Like other
axioms, its plausibility is subject to empirical investigation.
For example, if p is an even-chance gamble for

gamble for - 1/2 or

and p( 1/2) is an even-chance

THEOREM6. The axioms and representationof Theorem 4 in conjunctionwith A14,

X - = (- o, 0), and P2( - 1) = 1 imply that there is a real 9 > 0 such that p2(x) = Ix19
for all x E X-.
PROOF. It suffices to work with a = 1 in the context of Theorem 4. Let x denote
the measure that has probability 1 for x E X -. Given x < y < z < 0, consider x andy
as fixed, and let A(z) be the unique number in (0, 1) for which y-A(z)x + [1 -(z)]Z'.
Then

P2(Y) = p'(Z)P2(X) + [

(Z) ] P2(Z)

As z approaches 0, P2(Z)-*0 and A(z) increases. Let A* = sup{ A(z): 0 < z <y}. Then
P2(Y)= p'*P2(X),with M*< 1 since P2(X)> P2(Y). It also follows from A14 that

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405

RISK AS PROBABLE LOSS

= p*P2(>X) for every X > 0. Therefore
P2(AXY)

for x <y < O.

P2(Y)P2(AX) = P2(XY)P2(X)

> O.

Fix a scale for P2 by setting P2(- 1) = 1. Then y = - 1 in the preceding equation

gives P2(XX)= P2( - )p2(X) for X > 0 and x < - 1, and x = - 1 in the same equation
gives P2(AY)= P2( W2(Y) for X > 0 and - 1 < y < 0. It then follows from Theorem 3
(p. 41) in Aczel (1966) that p2(x) = Jx10for some 9 > 0. Q.E.D.
As noted earlier, the power function of Theorem 6 in conjunction with the linear Pi
form of Theorem 5 gives p(a, p) = af IIx1dp(x), a form that has been used in a generic
or specific (9 = 1, 2) way by several investigators. The more general form implicit in
Theorem 6, namely p(a, p) = pI(a)fIx19dp(x), adds flexibility by not requiring Pi to be
linear. For example, limited evidence from Coombs and Lehner (1981) suggests that Pi
increases at a decreasing rate for many individuals, as would be the case if p(a, p) +
p(a + 2A, p) <. 2p(a + A, p), or p(a + 2A,p)
A > 0.
6.

p(a + A, p) < p(a + A, p)

p(a, p) for

Summary and Acknowledgments

Although risk is pervasive in society, few attempts have been made to systematically characterize
perceived risk by an axiomatic formulation based on "is at least as risky as" applied to a set of probability
distributions on nonfavorable outcomes. My purpose here has been to consider general conditions that may
govern perceived risk that are based on a conventional understanding of risk and are influenced by
empirical studies on perceived risk for gambles. The numerical representations obtained from these
conditions were guided by prior axiomatizations of risk and preference, common-sense models of risk that
have appeared in the literature, and empirical findings on the effects of loss probability and loss amounts on
risk. Effects of gains on perceived risk will be examined in a sequel.'

'I am indebted to Duncan Luce for suggesting this study, and to Clyde Coombs and associates for their
pioneering research on risk measurement.

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