Mathematical Psychology
About

Cumulative Prospect Theory

Cumulative Prospect Theory extends the original prospect theory by applying probability weighting to cumulative distributions rather than individual probabilities, satisfying stochastic dominance.

V = Σ πᵢ · v(xᵢ) where πᵢ are rank-dependent weights

Cumulative Prospect Theory (CPT), published by Tversky and Kahneman in 1992, resolved a significant limitation of the original 1979 prospect theory: violations of first-order stochastic dominance. In the original theory, probability weighting was applied to individual outcome probabilities, which could lead to preferring dominated prospects. CPT applies weighting to cumulative probabilities instead, using a rank-dependent scheme.

Rank-Dependent Weighting

CPT Decision Weights For gains (ranked x₁ ≥ x₂ ≥ ... ≥ xₙ ≥ 0):
π₁⁺ = w⁺(p₁)
πᵢ⁺ = w⁺(p₁ + ... + pᵢ) − w⁺(p₁ + ... + pᵢ₋₁)

For losses (ranked similarly):
Decision weights use w⁻ applied to cumulative probabilities from below

The key innovation is that decision weights depend on the rank of each outcome, not just its probability. The best gain and worst loss receive disproportionate weight (because w overweights the tails of the cumulative distribution), while intermediate outcomes receive less weight. This captures the common observation that people focus on extreme outcomes.

Properties

CPT maintains all the psychologically important properties of original prospect theory — reference dependence, loss aversion, diminishing sensitivity — while satisfying stochastic dominance. It also allows separate probability weighting functions for gains (w⁺) and losses (w⁻), accommodating the empirical finding that the degree of probability distortion differs across domains. CPT is now the standard formulation used in behavioral economics, finance, and formal decision analysis.

Related Topics

References

  1. Tversky, A., & Kahneman, D. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty, 5(4), 297–323. https://doi.org/10.1007/BF00122574
  2. Quiggin, J. (1982). A theory of anticipated utility. Journal of Economic Behavior & Organization, 3(4), 323–343. https://doi.org/10.1016/0167-2681(82)90008-7
  3. Wakker, P. P. (2010). Prospect Theory: For Risk and Ambiguity. Cambridge University Press. https://doi.org/10.1017/CBO9780511779329
  4. Schmidt, U., Starmer, C., & Sugden, R. (2008). Third-generation prospect theory. Journal of Risk and Uncertainty, 36(3), 203–223. https://doi.org/10.1007/s11166-008-9040-2

External Links