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Stochastic Dominance and Cumulative Prospect Theory

Author

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  • Manel Baucells

    (IESE Business School, University of Navarra, Avenida Pearson 21, Barcelona 08034, Spain)

  • Franz H. Heukamp

    (IESE Business School, University of Navarra, Avenida Pearson 21, Barcelona 08034, Spain)

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.

Suggested Citation

  • Manel Baucells & Franz H. Heukamp, 2006. "Stochastic Dominance and Cumulative Prospect Theory," Management Science, INFORMS, vol. 52(9), pages 1409-1423, September.
    • Handle: RePEc:inm:ormnsc:v:52:y:2006:i:9:p:1409-1423
    DOI: 10.1287/mnsc.1060.0537
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    References listed on IDEAS

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