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What is the actual shape of perception utility?

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  • Kontek, Krzysztof

Abstract

Cumulative Prospect Theory (Kahneman, Tversky, 1979, 1992) holds that the value function is described using a power function, and is concave for gains and convex for losses. These postulates are questioned on the basis of recently reported experiments, paradoxes (gain-loss separability violation), and brain activity research. This paper puts forward the hypothesis that perception utility is generally logarithmic in shape for both gains and losses, and only happens to be convex for losses when gains are not present in the problem context. This leads to a different evaluation of mixed prospects than is the case with Prospect Theory: losses are evaluated using a concave, rather than a convex, utility function. In this context, loss aversion appears to be nothing more than the result of applying a logarithmic utility function over the entire outcome domain. Importantly, the hypothesis enables a link to be established between perception utility and Portfo-lio Theory (Markowitz, 1952A). This is not possible in the case of the Prospect Theory value function due its shape at the origin.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 31715.

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Date of creation: 20 Jun 2011
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Handle: RePEc:pra:mprapa:31715

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Keywords: Prospect Theory; value function; perception utility; loss aversion; gain-loss separability violation; neuroscience; Portfolio Theory; Decision Utility Theory.;

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  1. Nathalie Etchart-Vincent, 2009. "The shape of the utility function under risk in the loss domain and the "ruinous losses" hypothesis: some experimental results," Economics Bulletin, AccessEcon, vol. 29(2), pages 1393-1402.
  2. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, Econometric Society, vol. 66(3), pages 497-528, May.
  3. Michael H. Birnbaum & Jeffrey P. Bahra, 2007. "Gain-Loss Separability and Coalescing in Risky Decision Making," Management Science, INFORMS, INFORMS, vol. 53(6), pages 1016-1028, June.
  4. Mohammed Abdellaoui & Han Bleichrodt & Corina Paraschiv, 2007. "Loss Aversion Under Prospect Theory: A Parameter-Free Measurement," Management Science, INFORMS, INFORMS, vol. 53(10), pages 1659-1674, October.
  5. Tversky, Amos & Kahneman, Daniel, 1991. "Loss Aversion in Riskless Choice: A Reference-Dependent Model," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 106(4), pages 1039-61, November.
  6. John W. Payne & Dan J. Laughhunn & Roy Crum, 1980. "Translation of Gambles and Aspiration Level Effects in Risky Choice Behavior," Management Science, INFORMS, INFORMS, vol. 26(10), pages 1039-1060, October.
  7. Harry Markowitz, 1952. "The Utility of Wealth," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 60, pages 151.
  8. George Wu & Alex B. Markle, 2008. "An Empirical Test of Gain-Loss Separability in Prospect Theory," Management Science, INFORMS, INFORMS, vol. 54(7), pages 1322-1335, July.
  9. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, Springer, vol. 5(4), pages 297-323, October.
  10. Mohammed Abdellaoui & Han Bleichrodt & Olivier L’Haridon, 2008. "A tractable method to measure utility and loss aversion under prospect theory," Journal of Risk and Uncertainty, Springer, Springer, vol. 36(3), pages 245-266, June.
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