Cumulative prospect theory and gambling

David A. Peel, Michael Cain and D Law

No 2459, Working Papers from Lancaster University Management School, Economics Department

Abstract: Whilst Cumulative Prospect theory (CPT) provides an explanation of gambling on longshots at actuarially unfair odds, it cannot explain why people might bet on more favoured outcomes. This paper shows that this is explicable if the degree of loss aversion experienced by the agent is reduced for small-stake gambles (as a proportion of wealth), and probability distortions are greater over losses than gains. If the utility or value function is assumed to be bounded, the degree of loss aversion assumed by Kahneman and Tversky leads to absurd predictions, reminiscent of those pointed out by Rabin (2000), of refusal to accept infinite gain bets at low probabilities. Boundedness of the value function in CPT implies that the indifference curve between expected-return and win-probability will typically exhibit both an asymptote (implying rejection of an infinite gain bet) and a minimum at low probabilities, as the shape of the value function dominates the probability weighting function. Also the high probability section of the indifference curve will exhibit a maximum. These implications are consistent with outcomes observed in gambling markets.

Keywords: Cumulative prospect theory; exponential value function; gambling (search for similar items in EconPapers)
Date: 2005
View list of references

Downloads: (external link)
http://www.lums.lancs.ac.uk/publications/viewpdf/002459/ (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: http://EconPapers.repec.org/RePEc:lan:wpaper:002459

Access Statistics for this paper

More papers in Working Papers from Lancaster University Management School, Economics Department
Contact information at EDIRC.
Series data maintained by Richard Evans ().