On the Empirical Validity of Cumulative Prospect Theory: Experimental Evidence of Rank-Independent Probability Weighting

134 Pages Posted: 2 Apr 2019 Last revised: 26 May 2020

See all articles by B. Douglas Bernheim

B. Douglas Bernheim

Stanford University - Department of Economics; National Bureau of Economic Research (NBER)

Charles Sprenger

University of California, San Diego (UCSD) - Rady School of Management

Date Written: January 17, 2020

Abstract

Cumulative Prospect Theory (CPT), the leading behavioral account of decision making under uncertainty, avoids the dominance violations implicit in Prospect Theory (PT) by assuming that the probability weight applied to a given outcome depends on its ranking. We devise a simple and direct non-parametric method for measuring the change in relative probability weights resulting from a change in payoff ranks. We find no evidence that these weights are even modestly sensitive to ranks. Conventional calibrations of CPT preferences imply that the percentage change in probability weights should be an order of magnitude larger than we observe. It follows either that probability weighting is not rank-dependent, or that the weighting function is nearly linear. Non-parametric measurement of the change in relative probability weights resulting from changes in probabilities rules out the second possibility. Additional tests nevertheless indicate that the dominance patterns predicted by PT do not arise. We reconcile these findings by positing a form of complexity aversion that generalizes the well-known certainty effect.

Keywords: Prospect Theory, Cumulative Prospect Theory, rank dependence

JEL Classification: D81, D90

Suggested Citation

Bernheim, B. Douglas and Sprenger, Charles, On the Empirical Validity of Cumulative Prospect Theory: Experimental Evidence of Rank-Independent Probability Weighting (January 17, 2020). Econometrica, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3350196 or http://dx.doi.org/10.2139/ssrn.3350196

B. Douglas Bernheim (Contact Author)

Stanford University - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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Charles Sprenger

University of California, San Diego (UCSD) - Rady School of Management ( email )

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Rady School of Management
La Jolla, CA 92093
United States

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