A simple preference foundation of cumulative prospect theory with power utility

Abstract

Most empirical studies of rank-dependent utility and cumulative prospect theory have assumed power utility functions, both for gains and for losses. As it turns out, a remarkably simple preference foundation is possible for such models: Tail independence (a weakening of comonotonic independence which underlies all rank-dependent models) together with constant proportional risk aversion suffice, in the presence of common assumptions (weak ordering, continuity, and first stochastic dominance), to imply these models. Thus, sign dependence, the different treatment of gains and losses, and the separation of decision weights and utility are obtained free of charge.