An Axiomatization of Linear Cumulative Prospect Theory with Applications to Portfolio Selection and Insurance Demand

Ulrich Schmidt and Horst Zank

No 161, Royal Economic Society Annual Conference 2002 from Royal Economic Society

Abstract: The present paper combines loss attitudes and linear utility by providing an axiomatic analysis of corresponding preferences in a cumulative prospect theory (CPT) framework. CPT is one of the most promising alternatives to expected utility theory since it incorporates loss aversion, and linear utility for money receives increasing attention since it is often concluded in empirical research, and employed in theoretical applications. Rabin (2000) emphasizes the importance of linear utility, and highlights loss aversion as an explanatory feature for the disparity of significant small-scale risk aversion and reasonable large-scale risk aversion. In a sense we derive a two-sided variant of Yaari s dual theory, i.e. nonlinear probability weights in the presence of linear utility. The first important difference is that utility may have a kink at the status quo, which allows for the exhibition of loss aversion. Also, we may have different probability weighting functions for gains than for losses. The central condition of our model is termed independence of common increments. The applications of our model to portfolio selection and insurance demand show that CPT with linear utility has more realistic implications than the dual theory since it implies only a weakened variant of plunging.

Date: 2002-08-29
New Economics Papers: this item is included in nep-ias
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://repec.org/res2002/Schmidt.pdf full text

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:ecj:ac2002:161

Access Statistics for this paper

More papers in Royal Economic Society Annual Conference 2002 from Royal Economic Society Contact information at EDIRC.
Bibliographic data for series maintained by Christopher F. Baum ().