The main observation of CPT (and its predecessor Prospect Theory ) is that people tend to think of possible outcomes usually relative to a certain reference point (often the status quo) rather than to the final status, a phenomenon which is called framing effect. Moreover, they have different risk attitudes towards gains (i.e. outcomes above the reference point) and losses (i.e. outcomes below the reference point) and care generally more about potential losses than potential gains (loss aversion). Finally, people tend to overweight extreme, but unlikely events, but underweight "average" events. The last point is in contrast to Prospect Theory which assumes that people overweight unlikely events, independently of their relative outcomes. CPT incorporates these observations in a modification of Expected Utility Theory by replacing final wealth with payoffs relative to the reference point, replacing the utility function with a value function that depends on relative payoff, and replacing cumulative probabilities with weighted cumulative probabilities. In the general case, this leads to the following formula for subjective utility of a risky outcome described by probability measure : Differences from Prospect Theory The main modification to Prospect Theory is that, as in rank-dependent expected utility theory, cumulative probabilities are transformed, rather than the probabilities themselves. This leads to the aforementioned overweighting of extreme events which occur with small probability, rather than to an overweighting of all small probability events. The modification helps to avoid a violation of first order stochastic dominance and makes the generalization to arbitrary outcome distributions easier. CPT is, therefore, an improvement over Prospect Theory on theoretical grounds.
The main observation of CPT (and its predecessor prospect theory ) is that people tend to think of possible outcomes usually relative to a certain reference point (often the status quo) rather than to the final status, a phenomenon which is called framing effect. Moreover, they have different risk attitudes towards gains (i.e. outcomes above the reference point) and losses (i.e. outcomes below the reference point) and care generally more about potential losses than potential gains (loss aversion). Finally, people tend to overweight extreme, but unlikely events, but underweight "average" events. The last point is in contrast to Prospect Theory which assumes that people overweight unlikely events, independently of their relative outcomes. CPT incorporates these observations in a modification of expected utility theory by replacing final wealth with payoffs relative to the reference point, replacing the utility function with a value function that depends on relative payoff, and replacing cumulative probabilities with weighted cumulative probabilities. In the general case, this leads to the following formula for subjective utility of a risky outcome described by probability measure : Differences from prospect theory The main modification to prospect theory is that, as in rank-dependent expected utility theory, cumulative probabilities are transformed, rather than the probabilities themselves. This leads to the aforementioned overweighting of extreme events which occur with small probability, rather than to an overweighting of all small probability events. The modification helps to avoid a violation of first order stochastic dominance and makes the generalization to arbitrary outcome distributions easier. CPT is, therefore, an improvement over Prospect Theory on theoretical grounds.
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Prospect Theory
prospect theory
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Expected Utility Theory
expected utility theory
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Prospect Theory
prospect theory
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Prospect Theory
prospect theory