Risk-neutral firms can extract unbounded profits from consumers with prospect theory preferences

This paper considers the problem of a risk-neutral firm offering a gamble to consumers with preferences given by prospect theory. Under conditions satisfied by virtually all functional forms used in the literature, firms can extract arbitrarily high expected values from consumers. Moreover, for any given lottery, there exists another lottery that makes both the firm and the consumer better off. As a consequence, equilibria and Pareto optimal allocations do not exist in standard monopolistic or competitive models. © 2012 Elsevier Inc. All rights reserved. JEL classification: D81; D03