Direct Tests of Cumulative Prospect theory

124 Pages Posted: 2 Apr 2019

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 15, 2019

Abstract

Cumulative Prospect Theory (CPT), the leading behavioral account of decision making under uncertainty, assumes that the probability weight applied to a given outcome depends on its ranking. This assumption is needed to avoid the violations of dominance implied by Prospect Theory (PT). 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. The estimated changes in relative weights range from +3% to -3%, and in no case can we reject the hypothesis of rank-independence. Our estimates rule out changes in relative probability weights larger than a few percent as ranks change with 95% confidence. In contrast, conventional calibrations of CPT preferences for the same subjects imply that probability weights should change by 20% to 40%. Models with reference distributions (notably Koszegi and Rabin, 2006) have similar implications, and hence we falsify them as well. 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, Direct Tests of Cumulative Prospect theory (January 15, 2019). 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 )

Landau Economics Building
579 Serra Mall
Stanford, CA 94305-6072
United States
650-725-8732 (Phone)
650-725-5702 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Charles Sprenger

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

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

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