Template-Type: ReDIF-Paper 1.0
Author-Name: M Cain
Author-Name-First: M
Author-Name-Last: Cain
Author-Name: D Law
Author-Name-First: D
Author-Name-Last: Law
Author-Name: D Peel
Author-Name-First: D
Author-Name-Last: Peel
Title: Cumulative prospect theory and gambling
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.
Creation-Date: 2005
File-URL: http://www.lancaster.ac.uk/media/lancaster-university/content-assets/documents/lums/economics/working-papers/CumulativeProspectTheory.pdf
File-Format: application/pdf
Number: 566823
Classification-JEL: 
Keywords: Cumulative prospect theory, exponential value function, gambling
Handle: RePEc:lan:wpaper:566823