The utility function under Prospect Theory

Abstract

Prospect theory is the main behavioral alternative to expected utility. Tversky\nand Kahnemann (1992) motivate the utility function for gains and losses under\nprospect theory by using the axiom of preference homogeneity. However, they do not\nprovide the formal proof. We provide the relevant proof. Furthermore, we show that\nthe utility function under preference homogeneity obeys an additional and important\nrestriction that is not noted by Tversky and Kahnemann (1992). This simplifies the\nuse of prospect theory by reducing the number of free parameters by one.

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