Composition rules in original and cumulative prospect theory

Original and cumulative prospect theory differ in the composition rule used to combine the probability weighting function and the value function. We test the predictive power of these composition rules by performing a novel out-of-sample prediction test. We apply estimates of prospect theory’s weigh...

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Bibliographic Details
Published inTheory and decision Vol. 92; no. 3-4; pp. 647 - 675
Main Authors Gonzalez, Richard, Wu, George
Format Journal Article
LanguageEnglish
Published New York Springer US 01.04.2022
Springer Nature B.V
Subjects
Behavioral/Experimental Economics
Composition
Decision making
Domains
Economic Theory/Quantitative Economics/Mathematical Methods
Economics
Economics and Finance
Equivalence
Expected utility
Expected values
Finance
Game Theory
Heterogeneity
Insurance
Management
Operations Research/Decision Theory
Predictions
Probability
Prospect theory
Social and Behav. Sciences
Statistics for Business
Violations
Weighting
Weighting functions
Prospect theory
Probability weighting function
Rank-dependent expected utility
Composition rules
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ISSN0040-5833
1573-7187
DOI10.1007/s11238-022-09873-0

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Summary:Original and cumulative prospect theory differ in the composition rule used to combine the probability weighting function and the value function. We test the predictive power of these composition rules by performing a novel out-of-sample prediction test. We apply estimates of prospect theory’s weighting and value function obtained from two-outcome cash equivalents, a domain where original and cumulative prospect theory coincide, to three-outcome cash equivalents, a domain where the composition rules of the two theories differ. Although both forms of prospect theory predict three-outcome cash equivalents very well, at the aggregate level, we find small but systematic under-prediction of cash equivalents for cumulative prospect theory and small but systematic over-prediction of cash equivalents for original prospect theory. We also observe substantial heterogeneity across subjects and types of gambles, some of which is accounted for by differences in the curvature and elevation of the weighting function across individuals. We also find differences in prediction related to whether the worst outcome is zero or non-zero.
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ISSN:0040-5833
1573-7187
DOI:10.1007/s11238-022-09873-0