Reformulating prospect theory to become a von Neumann–Morgenstern theory

Jack Clark Francis ()
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Jack Clark Francis: City University of New York (CUNY)

Review of Quantitative Finance and Accounting, 2021, vol. 56, issue 3, No 6, 965-985

Abstract: Abstract This paper reformulates Kahneman–Tversky’s (KT’s) cumulative prospect theory to become a von Neumann–Morgenstern (vNM) theory that is compatible with many existing economic, finance, psychology and decision theories. This vNM theory has the following desirable characteristics: consistently increasing utility of wealth, loss aversion, concave over favorable outcomes, convex over unfavorable outcomes, consistent preference for positively skewed outcomes and it spans the real line between $$ - \infty $$ - ∞ and $$ \infty $$ ∞ . The weighted probabilities in KT’s cumulative prospect theory do not align with the vNM requirement that the probabilities sum to one; nevertheless, important advantages are gained from this vNM assumption.

Keywords: Cube root function; Radical function; Kahneman and Tversky; Prospect theory; von Neumann–Morgenstern (vNM) utility function; Framing; Taylor series expansion; Mental accounting; Disposition effect; Narrow framing; Skewness (search for similar items in EconPapers)
JEL-codes: G1 (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (1)

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DOI: 10.1007/s11156-020-00915-8

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