On the predictions of cumulative prospect theory for third and fourth order risk preferences

Ivan Paya (), David Peel and Konstantinos Georgalos

Theory and Decision, 2023, vol. 95, issue 2, No 7, 337-359

Abstract: Abstract In this paper, we analyse higher-order risky choices by the representative cumulative prospect theory (CPT) decision maker from three alternative reference points. These are the status quo, average payout and maxmin. The choice tasks we consider in our analysis include binary risks, and are the ones employed in the experimental literature on higher order risk preferences. We demonstrate that the choices made by the representative subject depend on the reference point. If the reference point is the status quo and the lottery choices exhibit symmetric risk, we demonstrate that there is no third order reflection effect of lottery choices but there is a fourth order reflection effect. When the average payout is the reference point, we demonstrate that any third or fourth order lottery choice is possible dependent upon the lottery payoffs. However, under the assumption of maxmin reference point, the risky choices are prudent and temperate. In addition to these results, our analysis reveals that the representative CPT subject can choose combinations of second with third and fourth order risky options that differ from those in other major models of decision under risk. We contrast our theoretical predictions with the empirical results reported in the literature on higher order risk preferences and are able to reconcile some conflicting experimental evidence.

Keywords: Cumulative prospect theory; Decision making under risk; Experiments; Higher order risk preferences; Reflection effect (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://link.springer.com/10.1007/s11238-022-09920-w Abstract (text/html)
Access to full text is restricted to subscribers.

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:kap:theord:v:95:y:2023:i:2:d:10.1007_s11238-022-09920-w

Ordering information: This journal article can be ordered from
http://www.springer. ... ry/journal/11238/PS2

DOI: 10.1007/s11238-022-09920-w

Access Statistics for this article

Theory and Decision is currently edited by Mohammed Abdellaoui

More articles in Theory and Decision from Springer
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().