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Gambling and nonexpected utility: the perils of the power function

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  • D. Law
  • D. A. Peel

Abstract

The use of the power utility function is problematic in expected utility theory. We show that, this is also the case in cumulative prospect theory, where the power function violates the assumption of loss-aversion at small stake levels, so that an optimal model of gambling is precluded. In the case of rank-dependent expected utility it has the counterfactual implication that agents will gamble all of their wealth at actuarially unfair odds.

Suggested Citation

  • D. Law & D. A. Peel, 2007. "Gambling and nonexpected utility: the perils of the power function," Applied Economics Letters, Taylor & Francis Journals, vol. 14(2), pages 79-82.
    • Handle: RePEc:taf:apeclt:v:14:y:2007:i:2:p:79-82
    DOI: 10.1080/13504850500426103
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    References listed on IDEAS

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    1. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
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    3. Matthew Rabin, 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Econometrica, Econometric Society, vol. 68(5), pages 1281-1292, September.
    4. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    5. M Cain & D Law & D Peel, 2005. "Cumulative prospect theory and gambling," Working Papers 566823, Lancaster University Management School, Economics Department.
    6. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
    7. Joseph Golec & Maurry Tamarkin, 1998. "Bettors Love Skewness, Not Risk, at the Horse Track," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 205-225, February.
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    10. repec:lan:wpaper:3214 is not listed on IDEAS
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    Cited by:

    1. Feess, Eberhard & Müller, Helge & Schumacher, Christoph, 2016. "Estimating risk preferences of bettors with different bet sizes," European Journal of Operational Research, Elsevier, vol. 249(3), pages 1102-1112.

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