Economic Theory

, Volume 28, Issue 3, pp 665–679

Cumulative prospect theory and the St. Petersburg paradox

Research Article

DOI: 10.1007/s00199-005-0641-6

Cite this article as:
Rieger, M.O. & Wang, M. Economic Theory (2006) 28: 665. doi:10.1007/s00199-005-0641-6

Summary.

We find that in cumulative prospect theory (CPT) with a concave value function in gains, a lottery with finite expected value may have infinite subjective value. This problem does not occur in expected utility theory. The paradox occurs in particular in the setting and the parameter regime studied by Tversky and Kahneman [15] and in subsequent works. We characterize situations in CPT where the problem can be resolved. In particular, we define a class of admissible probability distributions and admissible parameter regimes for the weighting- and value functions for which finiteness of the subjective value can be proved. Alternatively, we suggest a new weighting function for CPT which guarantees finite subjective value for all lotteries with finite expected value, independent of the choice of the value function. Some of these results have already been found independently by Blavatskyy [4] in the context of discrete lotteries.

Keywords and Phrases:

Cumulative prospect theory Probability weighting function St. Petersburg paradox. 

Copyright information

© Springer-Verlag Berlin/Heidelberg 2006

Authors and Affiliations

  1. 1.University of ZürichMathematical InstituteZürichSWITZERLAND
  2. 2.ETH ZürichInstitute of Economics ResearchZürichSWITZERLAND