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Stochastic Dominance and Cumulative Prospect Theory

  • Baucells Alibés Manel

    ()

    (UNIVERSITY OF NAVARRA)

  • Heukamp Franz H.

    ()

    (UNIVERSIDAD DE NAVARRA)

We generalize and extend the second order stochastic dominance condition available for Expected Utility to Cumulative Prospect Theory. The new definitions include, among others, preferences represented by S-shaped value and inverse S-shaped probability weighting functions. The stochastic dominance conditions supply a framework to test different features of Cumulative Prospect Theory. In the experimental part of the working paper we offer a test of several joint hypotheses on the value function and the probability weighting function. Assuming empirically relevant weighting functions, we can reject the inverse S-shaped value function recently advocated by Levy and Levy (2002a), in favor of the S-shaped form. In addition, we find generally supporting evidence for loss aversion. Violations of loss aversion can be linked to subjects using the overall probability of winning as heuristic.

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Paper provided by Fundacion BBVA / BBVA Foundation in its series Working Papers with number 201061.

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Length: 44
Date of creation: Jan 2007
Date of revision:
Handle: RePEc:fbb:wpaper:201061
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  1. Schmidt, Ulrich & Traub, Stefan, 2002. "An Experimental Test of Loss Aversion," Journal of Risk and Uncertainty, Springer, vol. 25(3), pages 233-49, November.
  2. Mohammed Abdellaoui & Frank Vossmann & Martin Weber, 2005. "Choice-Based Elicitation and Decomposition of Decision Weights for Gains and Losses Under Uncertainty," Management Science, INFORMS, vol. 51(9), pages 1384-1399, September.
  3. Lattimore, Pamela K. & Baker, Joanna R. & Witte, Ann D., 1992. "The influence of probability on risky choice: A parametric examination," Journal of Economic Behavior & Organization, Elsevier, vol. 17(3), pages 377-400, May.
  4. Hong, Chew Soo & Karni, Edi & Safra, Zvi, 1987. "Risk aversion in the theory of expected utility with rank dependent probabilities," Journal of Economic Theory, Elsevier, vol. 42(2), pages 370-381, August.
  5. 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.
  6. Pamela K. Lattimore & Joanna R. Baker & A. Dryden Witte, 1992. "The Influence Of Probability on Risky Choice: A parametric Examination," NBER Technical Working Papers 0081, National Bureau of Economic Research, Inc.
  7. Levy, Haim & Wiener, Zvi, 1998. "Stochastic Dominance and Prospect Dominance with Subjective Weighting Functions," Journal of Risk and Uncertainty, Springer, vol. 16(2), pages 147-63, May-June.
  8. Camerer, Colin F. & Hogarth, Robin M., 1999. "The Effects of Financial Incentives in Experiments: A Review and Capital-Labor-Production Framework," Working Papers 1059, California Institute of Technology, Division of the Humanities and Social Sciences.
  9. Mohammed Abdellaoui, 2000. "Parameter-Free Elicitation of Utility and Probability Weighting Functions," Management Science, INFORMS, vol. 46(11), pages 1497-1512, November.
  10. Bowman, David & Minehart, Deborah & Rabin, Matthew, 1999. "Loss aversion in a consumption-savings model," Journal of Economic Behavior & Organization, Elsevier, vol. 38(2), pages 155-178, February.
  11. Langer, Thomas & Weber, Martin, 1999. "Prospect-Theory, Mental Accounting and Differences in Aggregated and Segregated Evaluation of Lottery Portfolios," Sonderforschungsbereich 504 Publications 99-64, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
  12. John Payne, 2005. "It is Whether You Win or Lose: The Importance of the Overall Probabilities of Winning or Losing in Risky Choice," Journal of Risk and Uncertainty, Springer, vol. 30(1), pages 5-19, January.
  13. Haim Levy, 1992. "Stochastic Dominance and Expected Utility: Survey and Analysis," Management Science, INFORMS, vol. 38(4), pages 555-593, April.
  14. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 73-92.
  15. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  16. Tversky, Amos & Wakker, Peter, 1995. "Risk Attitudes and Decision Weights," Econometrica, Econometric Society, vol. 63(6), pages 1255-80, November.
  17. Michael H. Birnbaum, 2005. "Three New Tests of Independence That Differentiate Models of Risky Decision Making," Management Science, INFORMS, vol. 51(9), pages 1346-1358, September.
  18. Moshe Levy & Haim Levy, 2002. "Prospect Theory: Much Ado About Nothing?," Management Science, INFORMS, vol. 48(10), pages 1334-1349, October.
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