Cumulative prospect theory and gambling
AbstractWhilst Cumulative Prospect theory (CPT) provides an explanation of gambling on longshots at actuarially unfair odds, it cannot explain why people might bet on more favoured outcomes. This paper shows that this is explicable if the degree of loss aversion experienced by the agent is reduced for small-stake gambles (as a proportion of wealth), and probability distortions are greater over losses than gains. If the utility or value function is assumed to be bounded, the degree of loss aversion assumed by Kahneman and Tversky leads to absurd predictions, reminiscent of those pointed out by Rabin (2000), of refusal to accept infinite gain bets at low probabilities. Boundedness of the value function in CPT implies that the indifference curve between expected-return and win-probability will typically exhibit both an asymptote (implying rejection of an infinite gain bet) and a minimum at low probabilities, as the shape of the value function dominates the probability weighting function. Also the high probability section of the indifference curve will exhibit a maximum. These implications are consistent with outcomes observed in gambling markets.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Lancaster University Management School, Economics Department in its series Working Papers with number 566823.
Date of creation: 2005
Date of revision:
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Bruno Jullien & Bernard Salanié, 1997.
"Estimating Preferences under Risk : The Case of Racetrack Bettors,"
97-39, Centre de Recherche en Economie et Statistique.
- Bruno Jullien & Bernard Salanie, 2000. "Estimating Preferences under Risk: The Case of Racetrack Bettors," Journal of Political Economy, University of Chicago Press, vol. 108(3), pages 503-530, June.
- Joseph Golec & Maurry Tamarkin, 1998. "Bettors Love Skewness, Not Risk, at the Horse Track," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 205-225, February.
- Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
- Richard H. Thaler & Eric J. Johnson, 1990. "Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice," Management Science, INFORMS, vol. 36(6), pages 643-660, June.
- Matthew Rabin, 2001.
"Risk Aversion and Expected-Utility Theory: A Calibration Theorem,"
Method and Hist of Econ Thought
- Matthew Rabin, 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Econometrica, Econometric Society, vol. 68(5), pages 1281-1292, September.
- Matthew Rabin, 2001. "Risk Aversion and Expected Utility Theory: A Calibration Theorem," Levine's Working Paper Archive 7667, David K. Levine.
- Rabin, Matthew, 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Department of Economics, Working Paper Series qt731230f8, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
- Matthew Rabin., 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Economics Working Papers E00-279, University of California at Berkeley.
- Mark J Machina, 1982.
""Expected Utility" Analysis without the Independence Axiom,"
Levine's Working Paper Archive
7650, David K. Levine.
- Machina, Mark J, 1982. ""Expected Utility" Analysis without the Independence Axiom," Econometrica, Econometric Society, vol. 50(2), pages 277-323, March.
- Matthew Rabin & Richard H. Thaler, 2001. "Anomalies: Risk Aversion," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 219-232, Winter.
- Amos Tversky & Daniel Kahneman, 1979.
"Prospect Theory: An Analysis of Decision under Risk,"
Levine's Working Paper Archive
7656, David K. Levine.
- Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
- Conlisk, John, 1993. " The Utility of Gambling," Journal of Risk and Uncertainty, Springer, vol. 6(3), pages 255-75, June.
- Charles T. Clotfelter & Philip J. Cook, 1989. "Selling Hope: State Lotteries in America," NBER Books, National Bureau of Economic Research, Inc, number clot89-1.
- Harry Markowitz, 1952. "The Utility of Wealth," Journal of Political Economy, University of Chicago Press, vol. 60, pages 151.
- Vaughan Williams, Leighton, 1999. "Information Efficiency in Betting Markets: A Survey," Bulletin of Economic Research, Wiley Blackwell, vol. 51(1), pages 1-30, January.
- Chris Starmer, 2000. "Developments in Non-expected Utility Theory: The Hunt for a Descriptive Theory of Choice under Risk," Journal of Economic Literature, American Economic Association, vol. 38(2), pages 332-382, June.
- Raymond D. Sauer, 1998. "The Economics of Wagering Markets," Journal of Economic Literature, American Economic Association, vol. 36(4), pages 2021-2064, December.
- Maschke, Mario & Schmidt, Ulrich, 2010.
"Das Wettmonopol in Deutschland: Status Quo und Reformansätze,"
Kiel Policy Brief
18, Kiel Institute for the World Economy (IfW).
- Maschke, Mario & Schmidt, Ulrich, 2010. "Das Wettmonopol in Deutschland: Status Quo und Reformansätze," Open Access Publications from Kiel Institute for the World Economy 32848, Kiel Institute for the World Economy (IfW).
- repec:ebl:ecbull:v:4:y:2007:i:26:p:1-10 is not listed on IDEAS
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Richard Evans).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.