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Cumulative prospect theory and gambling

Cain, M and Law, D and Peel, D (2005) Cumulative prospect theory and gambling. Working Paper. The Department of Economics, Lancaster University.

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    Abstract

    Whilst Cumulative Prospect theory (CPT) provides an explanation of gambling on longshots at actuarially unfair odds, it cannot explain why people might bet on more favoured outcomes. This paper shows that this is explicable if the degree of loss aversion experienced by the agent is reduced for small-stake gambles (as a proportion of wealth), and probability distortions are greater over losses than gains. If the utility or value function is assumed to be bounded, the degree of loss aversion assumed by Kahneman and Tversky leads to absurd predictions, reminiscent of those pointed out by Rabin (2000), of refusal to accept infinite gain bets at low probabilities. Boundedness of the value function in CPT implies that the indifference curve between expected-return and win-probability will typically exhibit both an asymptote (implying rejection of an infinite gain bet) and a minimum at low probabilities, as the shape of the value function dominates the probability weighting function. Also the high probability section of the indifference curve will exhibit a maximum. These implications are consistent with outcomes observed in gambling markets.

    Item Type: Monograph (Working Paper)
    Uncontrolled Keywords: Cumulative prospect theory ; exponential value function ; gambling
    Subjects:
    Departments: Lancaster University Management School > Economics
    ID Code: 48778
    Deposited By: ep_importer_pure
    Deposited On: 11 Jul 2011 22:12
    Refereed?: No
    Published?: Published
    Last Modified: 27 Jul 2012 01:14
    Identification Number:
    URI: http://eprints.lancs.ac.uk/id/eprint/48778

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