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Ulrich Schmidt - One of the best experts on this subject based on the ideXlab platform.
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A genuine foundation for Prospect Theory
Journal of Risk and Uncertainty, 2012Co-Authors: Ulrich Schmidt, Horst ZankAbstract:In most models of (cumulative) Prospect Theory, reference dependence of preferences is imposed beforehand and the location of the reference point is determined exogenously. This paper presents principles that provide critical tests and foundations for Prospect Theory preferences without assuming reference-dependent preferences a priori. Instead, reference dependence is derived from behavior and the reference point arises endogenously.
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Insurance demand and Prospect Theory
2012Co-Authors: Ulrich SchmidtAbstract:Empirical evidence has shown that people are unwilling to insure rare losses at subsidized premiums and at the same time take-up insurance for moderate risks at highly loaded premiums. This paper explores whether Prospect Theory, in particular diminishing sensitivity and loss aversion, can accommodate this evidence. A crucial factor for applying Prospect Theory to insurance problems is the choice of the reference point. We motivate and explore two possible reference points, state-dependent initial wealth and final wealth after buying full insurance. It turns out that particularly the latter reference point seems to provide a realistic explanation of the empirical evidence.
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Endogenous Prospect Theory
Open Access Publications from Kiel Institute for the World Economy, 2010Co-Authors: Ulrich Schmidt, Horst ZankAbstract:In previous models of (cumulative) Prospect Theory reference-dependence of preferences is imposed beforehand and the location of the reference point is exogenously determined. This paper provides an axiomatization of a new specification of cumulative Prospect Theory, termed endogenous Prospect Theory, where reference-dependence is derived from preference conditions and a unique reference point arises endogenously.
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Additive Utility in Prospect Theory
Management Science, 2009Co-Authors: Han Bleichrodt, Ulrich Schmidt, Horst ZankAbstract:Prospect Theory is currently the main descriptive Theory of decision under uncertainty. It generalizes expected utility by introducing nonlinear decision weighting and loss aversion. A difficulty in the study of multiattribute utility under Prospect Theory is to determine when an attribute yields a gain or a loss. One possibility, adopted in the theoretical literature on multiattribute utility under Prospect Theory, is to assume that a decision maker determines whether the complete outcome is a gain or a loss. In this holistic evaluation, decision weighting and loss aversion are general and attribute-independent. Another possibility, more common in the empirical literature, is to assume that a decision maker has a reference point for each attribute. We give preference foundations for this attribute-specific evaluation where decision weighting and loss aversion are depending on the attributes.
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Third-generation Prospect Theory
Journal of Risk and Uncertainty, 2008Co-Authors: Ulrich Schmidt, Chris Starmer, Robert SugdenAbstract:We present a new Theory of decision under uncertainty: third-generation Prospect Theory (PT^3). This retains the predictive power of previous versions of Prospect Theory, but extends that Theory by allowing reference points to be uncertain while decision weights are specified in a rank-dependent way. We show that PT^3 preferences respect a state-conditional form of stochastic dominance. The Theory predicts the observed tendency for willingness-to-accept valuations of lotteries to be greater than willingness-to-pay valuations. When PT^3 is made operational by using simple functional forms with parameter values derived from existing experimental evidence, it predicts observed patterns of the preference reversal phenomenon.
Robert Sugden - One of the best experts on this subject based on the ideXlab platform.
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Third-generation Prospect Theory
Journal of Risk and Uncertainty, 2008Co-Authors: Ulrich Schmidt, Chris Starmer, Robert SugdenAbstract:We present a new Theory of decision under uncertainty: third-generation Prospect Theory (PT^3). This retains the predictive power of previous versions of Prospect Theory, but extends that Theory by allowing reference points to be uncertain while decision weights are specified in a rank-dependent way. We show that PT^3 preferences respect a state-conditional form of stochastic dominance. The Theory predicts the observed tendency for willingness-to-accept valuations of lotteries to be greater than willingness-to-pay valuations. When PT^3 is made operational by using simple functional forms with parameter values derived from existing experimental evidence, it predicts observed patterns of the preference reversal phenomenon.
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Explaining preference reversal with third-generation Prospect Theory
2005Co-Authors: Ulrich Schmidt, Chris Starmer, Robert SugdenAbstract:We present a new Theory of decision under risk called third-generation Prospect Theory. A novel feature of our version of Prospect Theory is that, by allowing reference points to be uncertain, it is able to accommodate the phenomenon of preference reversal. While several previous theories of preference reversal have been proposed, thus far it has resisted explanation via any empirically plausible model of preferences. We investigate whether our explanation is empirically plausible. We find that the standard patterns of preference reversal are predicted for typical parameterisations of Prospect Theory already established in the empirical literature. Consequently we suggest that our model constitutes a best buy Theory: it offers the predictive power of previous variants of Prospect Theory and adds to that an explanation of preference reversal. The latter comes ‘free of charge’ since it involves no extra parameters and no re-parameterisation.
Jack S. Levy - One of the best experts on this subject based on the ideXlab platform.
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Applications of Prospect Theory to political science
Synthese, 2003Co-Authors: Jack S. LevyAbstract:Prospect Theory is an alternative Theory of choice under conditions of risk, and deviates from expected utility Theory by positing that people evaluate choices with respect to gains and losses from a reference point. They tend to overweight losses with respect to comparable gains and engage in risk-averse behavior with respect to gains and risk-acceptant behavior with respect to losses. They also respond to probabilities in a non-linear manner. I begin with an overview of Prospect Theory and some of the evidence upon which it is based, and then consider some of the implications of the Theory for American politics, international relations, and the law. I end with a brief discussion of some of the conceptual and methodological problems confronting the application of Prospect Theory to the study of politics.
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Prospect Theory rational choice and international relations
International Studies Quarterly, 1997Co-Authors: Jack S. LevyAbstract:A half-decade after the first systematic applications of Prospect Theory to international relations, scholars continue to debate its potential utility as a theoretical framework. Key questions include the validity of the experimental findings themselves, their relevance for real-world international behavior that involves high-stakes decisions by collective actors in interactive settings, and the conceptual status of Prospect Theory with respect to rational choice. In this essay I assess theoretical and methodological debates over these issues. I review work in social psychology and experimental economics and conclude that challenges to the external validity of Prospect Theory-based hypotheses for international behavior are much more serious than challenges to their internal validity. I emphasize the similarities between Prospect Theory and expected-utility Theory, argue that hypotheses regarding loss aversion and the reflection effect are easily subsumed within the latter, and that evidence of framing effects and nonlinear responses to probabilities are more problematic for the Theory. I conclude that priorities for future research include the construction of hypotheses on the framing of foreign policy decisions and research designs for testing them; the incorporation of framing, loss aversion, and the reflection effect into theories of collective and interactive decision making; and experimental research that is sensitive to the political and strategic context of foreign policy decision making.
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Prospect Theory and International Relations: Theoretical Applications and Analytical Problems
Political Psychology, 1992Co-Authors: Jack S. LevyAbstract:In this essay I evaluate the potential contribution of Prospect Theory to our understanding of international relations. I begin with the implications of loss aversion, the endowment effect, risk orientation, and framing for theoretical questions relating to the stability of the status quo in international politics, deterrence, bargaining, and preventive war. I then raise conceptual and methodological problems which complicate the theoretical and empirical application of Prospect Theory to international behavior. I illustrate my arguments with references to some recent attempts to use a Prospect Theory framework to guide case studies of crises decision-making. I conclude that in applying Prospect Theory to empirical cases, the analyst must demonstrate not only that empirical behavior is consistent with the Theory but also that the observed behavior cannot adequately be explained by a rational choice model which posits the maximization of expected value.
Marc Oliver Rieger - One of the best experts on this subject based on the ideXlab platform.
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Financial Market Equilibria with Cumulative Prospect Theory Preferences
2010Co-Authors: Enrico G. De Giorgi, Thorsten Hens, Marc Oliver RiegerAbstract:The paper first shows that financial market equilibria need not to exist if agents possess cumulative Prospect Theory preferences with piecewise-power value functions. This is due to the boundary behavior of the cumulative Prospect Theory value function, which might cause an infinite short-selling problem. But even when a non-negativity constraint on final wealth is added, non-existence can occur due to the non-convexity of CPT preferences, which might cause discontinuities in the agents' demand functions. This latter observation also implies that concavification arguments which has been used in portfolio allocation problems with CPT preferences do not apply to our general equilibrium setting with finite many agents. Existence of equilibria is established when non-negativity constraints on final wealth are imposed and there is a continuum of agents in the market. However, if the original Prospect Theory is used instead of cumulative Prospect Theory, then other discontinuity problems can cause non-existence of market equilibria even in this case.
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Financial Market Equilibria with Cumulative Prospect Theory
Journal of Mathematical Economics, 2010Co-Authors: Enrico G. De Giorgi, Thorsten Hens, Marc Oliver RiegerAbstract:The paper first shows that financial market equilibria need not to exist if agents possess cumulative Prospect Theory preferences with piecewise-power value functions. This is due to the boundary behavior of the cumulative Prospect Theory value function, which might cause an infinite short-selling problem. But even when a non-negativity constraint on final wealth is added, non-existence can occur due to the non-convexity of CPT preferences, which might cause discontinuities in the agents' demand functions. This latter observation also implies that concavification arguments which has been used in portfolio allocation problems with CPT preferences do not apply to our general equilibrium setting with finite many agents. Existence of equilibria is established when non-negativity constraints on final wealth are imposed and there is a continuum of agents in the market. However, if the original Prospect Theory is used instead of cumulative Prospect Theory, then other discontinuity problems can cause non-existence of market equilibria even in this case.
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Evolutionary Stability of Prospect Theory Preferences
SSRN Electronic Journal, 2009Co-Authors: Marc Oliver RiegerAbstract:We demonstrate that in simple 2×2 games (cumulative) Prospect Theory preferences can be (semi-)evolutionarily stable, in particular, a population of players with Prospect Theory preferences is stable against more rational players, i.e. players with a smaller degree of probability weighting. We also show that in a typical game with infinitely many strategies, the “war of attrition”, probability weighting is (semi-)evolutionarily stable. Finally, we generalize to other notions of stability. Our results may help to explain why probability weighting is generally observed in humans, although it is not optimal in usual decision problems.
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Prospect Theory for continuous distributions
Journal of Risk and Uncertainty, 2008Co-Authors: Marc Oliver Rieger, Mei WangAbstract:We extend the original form of Prospect Theory by Kahneman and Tversky from finite lotteries to arbitrary probability distributions, using an approximation method based on weak-⋆ convergence. The resulting formula is computationally easier than the corresponding formula for cumulative Prospect Theory and makes it possible to use Prospect Theory in future applications in economics and finance. Moreover, we suggest a method how to incorporate a crucial step of the “editing phase” into Prospect Theory and to remove in this way the discontinuity of the original model.
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Prospect Theory for Continuous Distributions Games and Prospects
2007Co-Authors: Marc Oliver Rieger, Mei WangAbstract:We extend the original form of Prospect Theory by Kahneman and Tversky from finite lotteries to arbitrary probability distributions, thus paving the way for applications in economics and finance. Moreover, we suggest a method how to incorporate a crucial step of the “editing phase” into Prospect Theory and to remove in this way the discontinuity of the original model.
Peter P Wakker - One of the best experts on this subject based on the ideXlab platform.
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Prospect Theory for continuous distributions: A preference foundation
Journal of Risk and Uncertainty, 2011Co-Authors: Amit Kothiyal, Vitalie Spinu, Peter P WakkerAbstract:Preference foundations give necessary and sufficient conditions for a decision model, stated directly in terms of the empirical primitive: the preference relation. For the most popular descriptive model for decision making under risk and uncertainty today, Prospect Theory, preference foundations have as yet been provided only for Prospects taking finitely many values. In applications, however, Prospects often are complex and involve infinitely many values, as in normal and lognormal distributions. This paper provides a preference foundation of Prospect Theory for such complex Prospects. We allow for unbounded utility and only require finite additivity of the underlying probability distributions, leaving the restriction to countably additive distributions optional. As corollaries, we generalize previously obtained preference foundations for special cases of Prospect Theory (rank-dependent utility and Choquet expected utility) that all required countable additivity. We now obtain genuine generalizations of de Finetti’s and Savage’s finitely additive setups to unbounded utility.
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Prospect Theory for risk and ambiguity
2010Co-Authors: Peter P WakkerAbstract:Preface Introduction Part I. Expected Utility: 1. The general model of decision under uncertainty no-arbitrage (expected utility with known utilities and unknown probabilities) 2. Expected utility with known probabilities - 'risk' - and unknown utilities 3. Applications of expected utility for risk 4. Expected utility with unknown probabilities and unknown utilities Part II. Nonexpected Utility for Risk: 5. Heuristic arguments for probabilistic sensitivity and rank dependence 6. Probabilistic sensitivity and rank dependence analyzed 7. Applications and extensions of rank dependence 8. Where Prospect Theory deviates from rank-dependent utility and expected utility: reference dependence versus asset integration 9. Prospect Theory for decision under risk Part III. Nonexpected Utility for Uncertainty: 10. Extending rank-dependent utility from risk to uncertainty 11. Ambiguity: where uncertainty extends beyond risk 12. Prospect Theory for uncertainty 13. Conclusion Appendices References Index.
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The Data of Levy and Levy (2002) Prospect Theory: Much Ado About Nothing? Actually Support Prospect Theory
Management Science, 2003Co-Authors: Peter P WakkerAbstract:Levy and Levy ( Management Science 2002) present data that, according to their claims, violate Prospect Theory. They suggest that Prospect Theory's hypothesis of an S-shaped value function, concave for gains and convex for losses, is incorrect. However, all the data of Levy and Levy are perfectly consistent with the predictions of Prospect Theory, as can be verified by simply applying Prospect Theory formulas. The mistake of Levy and Levy is that they, incorrectly, thought that probability weighting could be ignored.
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Original and cumulative Prospect Theory: a discussion of empirical differences
Journal of Behavioral Decision Making, 1997Co-Authors: Hein Fennema, Peter P WakkerAbstract:This note discusses differences between Prospect Theory and cumulative Prospect Theory. It shows that cumulative Prospect Theory is not merely a formal correction of some theoretical problems in Prospect Theory, but it also gives different predictions. Experiments are described that favor cumulative Prospect Theory.
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An axiomatization of cumulative Prospect Theory
1993Co-Authors: Peter P Wakker, Amos TverskyAbstract:textabstractThis paper presents a method for axiomatizing a variety of models for decision making under uncertainty, including Expected Utility and Cumulative Prospect Theory. This method identifies, for each model, the situations that permit consistent inferences about the ordering of value differences. Examples of rankdependent and sign-dependent preference patterns are used to motivate the models and the tradeoff consistency axioms that characterize them. The major properties of the value function in Cumulative Prospect Theory—diminishing sensitivity and loss aversion—are contrasted with the principle of diminishing marginal utility that is commonly assumed in Expected Utility.
