and Preferences Under Risk

This article investigates which forms of preferences under risk are consistent with pro…t-maximizing lotto games. To do so, I depart from the approach employed by Friedman and Savage (1948) by introducing a reference point against which changes in wealth are valued and probability transformation. Both alterations make the model directly comparable to experimental results found in the context of Cumulative Prospect Theory. By exploiting some basic stylized facts about the prize distribution of lotto games, a number of restrictions on preferences are found. The value function must be globally concave over the domain of positive prizes offered by the lottery, and the probability weighting function concave for low probabilities in the gain domain and concave in average for low probabilities in the loss domain. Remarkably, all these properties match the corresponding results found in the experimental literature