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Stochastic Dominance and Cumulative Prospect Theory

IESE Business School, University of Navarra, Avenida Pearson 21, Barcelona 08034, Spain
IESE Business School, University of Navarra, Avenida Pearson 21, Barcelona 08034, Spain
mbaucells{at}iese.edu
fheukamp{at}iese.edu

We generalize and extend the second-order stochastic dominance condition for expected utility to cumulative prospect theory. The new definitions include preferences represented by S-shaped value functions, inverse S-shaped probability weighting functions, and loss aversion. The stochastic dominance conditions supply a framework to test different features of cumulative prospect theory. In the experimental part of the paper, we offer a test of several joint hypotheses on the value function and the probability weighting function. Assuming empirically relevant weighting functions, we can reject the inverse S-shaped value function recently advocated by Levy and Levy (2002) in favor of the S-shaped form. In addition, we find generally supporting evidence for loss aversion. Violations of loss aversion can be explained by subjects using the overall probability of winning as a heuristic.

Key Words: second-order stochastic dominance; cumulative prospect theory; value function; probability weighting function
History: Received: July 25, 2004;

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