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Stochastic Dominance and Cumulative Prospect Theory

Manel Baucells () and Franz H. Heukamp ()
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Franz H. Heukamp: IESE Business School, University of Navarra, Avenida Pearson 21, Barcelona 08034, Spain

Management Science, 2006, vol. 52, issue 9, 1409-1423

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 (search for similar items in EconPapers)
Date: 2006
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