A Context Dependent Model of Decision Making Under Risk

Abstract

This paper presents a context dependent valuation (CDV) model of decision making under risk where the valuation of a gamble depends not only on its own probability-outcome structure but also on the other gambles that it is compared with. This descriptive model draws motivation from the range-frequency theory (Parducci 1965, 1968) which is a psychophysical theory concerned with the judgment of categories like good and bad or large and small and states that the subjective value given to a stimulus depends on its position as well as its rank in the set of observed stimuli. The CDV model is deterministic, based on the value maximization paradigm, uses lesser number of parameters than cumulative prospect theory and is shown to explain and predict 1) violation of non-transparent stochastic dominance (while retaining transparent stochastic dominance), 2) procedure invariance in the form of a buying-selling price gaps, preference reversals and elicitation biases, 3) description invariance in the form of juxtaposition, event splitting and framing effects, and 4) classical phenomena such as the 4-fold pattern of risk attitudes, violation of monotonicity, the common consequence effect and the common ratio effect. In addition, the way the model can be used to predict changes in behavior patterns with changes in specific parameters of a choice situation is demonstrated.