What is the Actual Shape of Perception Utility?
18 Pages Posted: 21 Jun 2011
Date Written: May, 18 2011
Cumulative Prospect Theory (Kahneman, Tversky, 1979, 1992) holds that the value function is described using a power function, and is concave for gains and convex for losses. These postulates are questioned on the basis of recently reported experiments, paradoxes (gain-loss separability violation), and brain activity research. This paper puts forward the hypothesis that perception utility is generally logarithmic in shape for both gains and losses, and only happens to be convex for losses when gains are not present in the problem context. This leads to a different evaluation of mixed prospects than is the case with Prospect Theory: losses are evaluated using a concave, rather than a convex, utility function. In this context, loss aversion appears to be nothing more than the result of applying a logarithmic utility function over the entire outcome domain. Importantly, the hypothesis enables a link to be established between perception utility and Portfolio Theory (Markowitz, 1952A). This is not possible in the case of the Prospect Theory value function due its shape at the origin.
Keywords: prospect theory, value function, perception utility, loss aversion, gain-loss separability violation, neuroscience, portfolio theory, decision utility theory
JEL Classification: C91, D03, D81, D87, G11
Suggested Citation: Suggested Citation