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Multi-Outcome Lotteries: Prospect Theory vs. Relative Utility

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  • Kontek, Krzysztof

Abstract

This paper discusses two approaches for the analysis of multi-outcome lotteries. The first uses Cumulative Prospect Theory. The second is the Relative Utility Function, which strongly resembles the utility function hypothesized by Markowitz (1952). It is shown that the relative utility model follows Expected Utility Theory with a transformed outcome domain. An illustrative example demonstrates that not only it is a simpler model, but it also provides more sound predictions regarding certainty equivalents of multi-outcome lotteries. The paper discusses estimation procedures for both models. It is noted that Cumulative Prospect Theory has been derived using two-outcome lotteries only, and it is hard to find any evidence in the literature of its parameters ever having been estimated by using lotteries with more than two outcomes. Least squares (mean) and quantile (including median) regression estimations are presented for the relative utility model. It turns out that the estimations for two- and three-outcome lotteries are essentially the same. This confirms the correctness of the model and vindicates the homogeneity of responses given by subjects. An additional advantage of the relative utility model is that it allows multi-outcome lotteries, together with the estimation results, to be presented on a single graph. This is not possible using Cumulative Prospect Theory.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 22947.

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Date of creation: 28 May 2010
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Handle: RePEc:pra:mprapa:22947

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Keywords: Multi-Prize Lotteries; Lottery / Prospect Valuation; Markowitz Hypothesis; Prospect / Cumulative Prospect Theory; Aspiration / Relative Utility Function.;

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References

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  1. John D Hey & Andrea Morone & Ulrich Schmidt, 2007. "Noise and Bias in Eliciting Preferences," Discussion Papers, Department of Economics, University of York 07/04, Department of Economics, University of York.
  2. Kontek, Krzysztof, 2010. "Density Based Regression for Inhomogeneous Data: Application to Lottery Experiments," MPRA Paper 22268, University Library of Munich, Germany.
  3. Kontek, Krzysztof, 2009. "On Mental Transformations," MPRA Paper 16516, University Library of Munich, Germany.
  4. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, Econometric Society, vol. 47(2), pages 263-91, March.
  5. Kontek, Krzysztof, 2010. "Mean, Median or Mode? A Striking Conclusion From Lottery Experiments," MPRA Paper 21758, University Library of Munich, Germany.
  6. Krzysztof Kontek, 2009. "Lottery valuation using the aspiration / relative utility function," Working Papers, Department of Applied Econometrics, Warsaw School of Economics 39, Department of Applied Econometrics, Warsaw School of Economics.
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Cited by:
  1. Kontek, Krzysztof, 2010. "Classifying Behaviors in Risky Choices," MPRA Paper 23845, University Library of Munich, Germany.

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