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

Ali al-Nowaihi () and Sanjit Dhami

No 10/11, Discussion Papers in Economics from Division of Economics, School of Business, University of Leicester

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.

Keywords: Decision making under risk; Composite Prelec probability weighting functions; Composite cumulative prospect theory; Composite rank dependent utility theory; Insurance; St. Petersburg paradox; Becker.s paradox (search for similar items in EconPapers)
JEL-codes: C60 D81 (search for similar items in EconPapers)
Date: 2010-04
New Economics Papers: this item is included in nep-evo, nep-neu and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

Downloads: (external link)
https://www.le.ac.uk/economics/research/RePEc/lec/leecon/dp10-11.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:lec:leecon:10/11

Ordering information: This working paper can be ordered from
https://www2.le.ac.u ... -1/discussion-papers

Access Statistics for this paper

More papers in Discussion Papers in Economics from Division of Economics, School of Business, University of Leicester School of Business, University of Leicester, University Road. Leicester. LE1 7RH. UK Provider-Homepage: https://le.ac.uk/school-of-business. Contact information at EDIRC.
Bibliographic data for series maintained by Abbie Sleath ().