Stochastic dominance and cumulative prospect theory

Stochastic dominance and cumulative prospect theory

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Article ID: iaor20081186
Country: United States
Volume: 52
Issue: 9
Start Page Number: 1409
End Page Number: 1423
Publication Date: Sep 2006
Journal: Management Science
Authors: ,
Keywords: prospect theory
Abstract:

We generalize and extend the second-order stochastic dominance condition for expected utility to cumulative prospect theory. The new definitions include preferences represented by S-shaped value functions, inverse S-shaped probability weighting functions, and loss aversion. The stochastic dominance conditions supply a framework to test different features of cumulative prospect theory. In the experimental part of the 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 in favor of the S-shaped form. In addition, we find generally supporting evidence for loss aversion. Violations of loss aversion can be explained by subjects using the overall probability of winning as a heuristic.

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