Stochastic Dominance and Cumulative Prospect Theory

Second order stochastic dominance characterizes risk-averse preferences represented by expected utility. This paper supplies second order stochastic dominance conditions that characterize preferences represented by Cumulative Prospect Theory. In contrast to previous attempts, here we take into account the effect of an inverse S-shaped probability weighting function. Among other applications, the stochastic dominance conditions are useful to design non-parametric tests of Cumulative Prospect Theory. In the experimental part, after characterizing both S-shaped and inverse S-shaped value functions by means of stochastic dominance conditions, we test which type of value function describes better decision-making under risk. Our experiments reject the inverse S-shaped value function recently advocated by Levy and Levy (2002a). With loss aversion included in the stochastic dominance notions, we probe for loss aversion and find general supporting evidence. Violations of loss aversion can be l...

• Type: Journal
• Year: 2006
• Where: MANSCI
• Authors: Manel Baucells, Franz H. Heukamp
• Keywords: Cumulative Prospect Theory, MANSCI 2006, Stochastic Dominance, Stochastic Dominance Conditions