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When 0 + 1/3+1/3>2/3, but 0 + 0 +1/3

Author

Listed:
  • Krzysztof Kontek
  • Michael Birnbaum
Abstract
This paper presents the results of two experiments that exhibit monotonicity violations: some lotteries with three equally likely outcomes are valued more than a superior two-outcome lottery, while others are valued less than an inferior two-outcome lottery. Moreover the experimental data provide compelling evidence that lottery valuation strongly depends on the value(s) of the middle outcome(s). This contradicts the claim of Cumulative Prospect Theory (CPT) that middle outcomes are assigned lower weights than the extreme ones. Both effects can be observed in the case of four-outcome lotteries. The patterns are persistent for various payoff schedules, and have been observed for subjects from both Poland and California. Incorporating the median outcome value into any modeling of risky decision-making enables these effects to be explained. This paper demonstrates that a simple weighted Expected Utility - Median model describes data involving two- three-, and four-outcome lotteries more accurately than CPT. Moreover, it offers an alternative explanation of ''overweighting'' of small probabilities, and ''underweighting'' of large ones – phenomena postulated by CPT.

Suggested Citation

  • Krzysztof Kontek & Michael Birnbaum, 2016. "When 0 + 1/3+1/3>2/3, but 0 + 0 +1/3," KAE Working Papers 2016-016, Warsaw School of Economics, Collegium of Economic Analysis.
    • Handle: RePEc:sgh:kaewps:2016016
    as

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    File URL: http://kolegia.sgh.waw.pl/pl/KAE/Documents/WorkingPapersKAE/WPKAE_2016_016.pdf
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    References listed on IDEAS

    as
    1. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    2. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
    3. Viscusi, W Kip, 1989. "Prospective Reference Theory: Toward an Explanation of the Paradoxes," Journal of Risk and Uncertainty, Springer, vol. 2(3), pages 235-263, September.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    decision – making under risk; monotonicity violations; Expected Utility Theory (EUT); Cumulative Prospect Theory; median;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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