Reduction of Compound Lotteries under Cumulative Prospect Theory
AbstractUnder expected utility theory, compound lotteries can be reduced to simple lotteries since unconditional expected utility can be decomposed into a weighted average of conditional expected utilities where the weights are marginal probabilities. We derive necessary and sufficient conditions for a similar decomposition in the framework of Cumulative Prospect Theory (CPT) when a decision maker has to choose between prospects that belong to a comonotonic class. Our conditions characterize the compatibility of a prominent alternative to expected utility with valuation methods that are commonly used in applied economics and finance, e.g. in binomial option pricing.
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 Queen's University, Department of Economics in its series Working Papers with number 1228.
Length: 13 pages
Date of creation: Dec 2009
Date of revision:
Cumulative Prospect Theory; probability weighting function; conditioning; updating; dynamic consistency; model consistency; consequentialism; valuation methods;
Find related papers by JEL classification:
- D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
- D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-02-13 (All new papers)
- NEP-CBE-2010-02-13 (Cognitive & Behavioural Economics)
- NEP-NEU-2010-02-13 (Neuroeconomics)
- NEP-UPT-2010-02-13 (Utility Models & Prospect Theory)
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.:
- Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
- Sarin, R. & Wakker, P.P., 1996.
"Revealed likelihood and knightian uncertainty,"
1996-59, Tilburg University, Center for Economic Research.
- 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.
- Itzhak Gilboa & David Schmeidler, 1991.
"Updating Ambiguous Beliefs,"
924, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- Wakker, Peter & Tversky, Amos, 1993. " An Axiomatization of Cumulative Prospect Theory," Journal of Risk and Uncertainty, Springer, vol. 7(2), pages 147-75, October.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Mark Babcock).
If references are entirely missing, you can add them using this form.