Stochastic Dominance and Cumulative Prospect Theory
Manel Baucells, Franz H. Heukamp
Management Science · 2006 · Volume 52 · Issue 9
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 (2002) 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.
Keywords
second-order stochastic dominance, cumulative prospect theory, value function, probability weighting function
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