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Composite Prospect Theory: A proposal to combine ‘prospect theory’ and ‘cumulative prospect theory’

By Ali al-Nowaihi and Sanjit Dhami

Abstract

Evidence shows that (i) people overweight low probabilities and underweight high probabilities, but (ii) ignore events of extremely low probability and treat extremely high probability events as certain. The main alternative decision theories, rank dependent utility (RDU) and cumulative prospect theory (CP) incorporate (i) but not (ii). By contrast, prospect theory (PT) addresses (i) and (ii) by proposing an editing phase that eliminates extremely low probability events, followed by a decision phase that only makes a choice from among the remaining alternatives. However, PT allows for the choice of stochastically dominated options, even when such dominance is obvious. We propose to combine PT and CP into composite cumulative prospect theory (CCP). CCP combines the editing and decision phases of PT into one phase and does not allow for the choice of stochastically dominated options. This, we believe, provides the best available alternative among decision theories of risk at the moment. As illustrative examples, we also show that CCP allows us to resolve three paradoxes: the insurance paradox, the Becker paradox and the St. Petersburg paradox

Topics: Decision making under risk, Composite Prelec probability weighting, Composite cumulative prospect theory, Composite rank dependent utility, Insurance, St. Petersburg paradox, Becker s paradox
Publisher: Dept. of Economics, University of Leicester
Year: 2010
OAI identifier: oai:lra.le.ac.uk:2381/8297

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