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on Utility Models and Prospect Theories |
| By: | Travis D. Nesmith |
| Abstract: | This paper analyzes the necessary and sufficient conditions for solving money-in-the-utility-function models when contemporaneous asset returns are uncertain. A unique solution to such models is shown to exist under certain measurability conditions. Stochastic Euler equations, whose existence is normally assumed in these models, are then formally derived. The regularity conditions are weak, and economically innocuous. The results apply to the broad range of discrete-time monetary and financial models that are special cases of the model used in this paper. The method is also applicable to other dynamic models that incorporate contemporaneous uncertainty. |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgfe:2005-52&r=upt |
| By: | Massimo Guidolin; Giovanna Nicodano |
| Abstract: | This paper investigates how variance risk affects the portfolio choice of an investor faced with an international asset menu that includes European and North American small equity portfolios. Small capitalization stocks are known to display asymmetric risk across bull and bear markets. Therefore we model stock returns as generated by a multivariate regime switching process that is able to account for both non-normality and predictability of stock returns. Non-normality matters for portfolio choice because the investor has a power utility function, implying a preference for positively skewed returns and aversion to kurtosis. We find that small cap portfolios, that are shown to display negative co-skewness with other assets, command large optimal weights only when regime switching, and hence variance risk, is ignored. Otherwise a rational investor ought to hold a well-diversified portfolio. However, the availability of small caps substantially increases expected utility, in the order of riskless annualized gains of 3 percent and higher. |
| Keywords: | Investments, Foreign |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2005-075&r=upt |
| By: | Chiaki Hara (Institute of Economic Research, Kyoto University) |
| Abstract: | We prove that every continuous-time model in which all consumers have time-homogeneous and time-additive utility functions and share a common probabilistic belief and a common discount rate can be reduced to a static model. This result allows us to extend some of the existing results on the representative consumer and risk-sharing rules in static models to continuous-time models. We show that the equilibrium interest rate is lower and more volatile than in the standard representative consumer economy, and that the individual consumption growth rates are more dispersed than is predicted from the first-order conditions. |
| Keywords: | Heterogeneity, risk attitudes, hyperbolic absolute risk aversion, representative consumer, risk-sharing rules, mutual fund theorem, Ito's Lemma, interest rates. |
| JEL: | D51 D58 D81 D91 G11 G12 G13 |
| Date: | 2005–12 |
| URL: | http://d.repec.org/n?u=RePEc:kyo:wpaper:609&r=upt |
| By: | Lorenz Goette (University of Zurich and CEPR and IZA Bonn); David Huffman (IZA Bonn) |
| Abstract: | This chapter argues that the neglect of emotion in economic models explains their inability to predict important aspects of the labor market. We focus on one example: firms frequently cut real wages, increasing nominal wages by less than the inflation rate, but they very seldom cut nominal wages. This pattern suggests that workers exhibit a special resistance to nominal wage cuts, which is hard to explain if they are purely rational as assumed in standard economic models. We argue that resistance to nominal wage cuts is best understood in terms of a model where salient features of a situation trigger emotional responses and sway judgment of the entire situation. Since a cut in the nominal wage leads to a very salient reduction in pay, we argue that the reaction of workers is dominated by emotions. On the other hand, an increase in the nominal wage may produce a more deliberative evaluation, because there is no immediately salient feature. The individual needs to compare the inflation rate to the wage change before it becomes clear whether the change increases or decreases utility, thus producing a more measured response. We present evidence from experiments showing that self-reported emotions respond strongly to nominal wage cuts, but not to decreases in the real wage achieved through increasing the nominal wage by less than the inflation rate. Although emotions may benefit individual workers, by strengthening their bargaining position and preventing wage cuts, they may also lead to worse outcomes, in the form of higher unemployment. |
| Keywords: | wage rigidity, affect, emotions, money illusion, loss aversion |
| JEL: | E24 E31 E32 B49 |
| Date: | 2005–12 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp1895&r=upt |
| By: | Henry Saffer |
| Abstract: | In this paper social interaction is modeled as a consumer good. Social interaction may provide an externality in the form of social capital, but the primary reason that individuals engage in social interaction is that these activities directly yield utility. It is important to note that some measures of social interaction show declines while many do not. A model of household production is employed to derive the demand for social interaction. The model shows that the demand for social interaction is a function of its price, the price of other goods and income. The role of children and marriage in social interaction can also be explained in the model. The theory is tested with data from the General Social Survey (GSS) and the results show that social interaction can be explained as the consequence of utility maximizing behavior by individuals. Increases in education generally increase memberships but reduce visiting with relatives and friends. Increases in income generally increase memberships and some forms of visiting. The model predicts 70 percent, or more, of the time trends in social interaction. These results are in contrast to social capital theorists who have focused on the declines in social interaction and who have attributed these changes to factors such as increased community heterogeneity and increased television viewing. |
| JEL: | Z13 |
| Date: | 2005–12 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:11881&r=upt |
| By: | Frode Brevik; Stefano d'Addona |
| Abstract: | Building on Veronesi (2000), we investigate the relationship between the quality of information on the state of the economy and the equity risk premium. We analyze the driving forces of the premium in a regime-switching setup where agents have Epstein-Zin preferences, finding a remarkably rich relation between the required risk premium and the quality of information available to investors. In particular, relaxing the strict relationship between investors' elasticity of intertemporal substitution (EIS) and their degree of risk aversion (RA) embedded in a power utility function enables us to demonstrate how the required equity premium is determined by their interplay. As conjectured in the existing literature, we demonstrate that investors with a high EIS will require less excess returns for holding stocks if they are provided with better information on the state of the economy. More interestingly, and not predicted in the literature, we find that this will also hold for investors with a moderate EIS if they are sufficiently risk averse. |
| JEL: | E32 E37 G10 G12 |
| Date: | 2005–12 |
| URL: | http://d.repec.org/n?u=RePEc:usg:dp2005:2005-24&r=upt |
| By: | QIU-HONG WANG (National University of Singapore); KAI-LUNG HUI (National University of Singapore) |
| Abstract: | This study relaxes the conventional assumption in the literature of new product introduction that all consumers possess nothing at the beginning of the game. We generalize consumers’ utility function to a market in the presence of an installed base and characterize its specific properties pertaining to various market contexts with different consumer heterogeneity and technology improvement. In such a general setting, we investigate various feasible combinations of timing, pricing and product line strategies that the seller can employ in a two-period game for selling the new product to consumers with different purchase history and heterogeneous preference on product quality. Our subgame-perfect- equilibrium results suggest that other than the upgrade policy, the seller can maximize her profits via intertemporal price discrimination, or delayed introduction, or pooling pricing, depending on the characteristics of market structure and technology improvement. Without the concern about cost, social welfare directly depends on whether the seller can sustain her monopoly power facing the mutual cannibalization between the old and new products and the mutual arbitrage between the heterogeneous consumers. |
| Keywords: | New product introduction, intertemporal price discrimination, delayed product introduction, installed base, upgrade policy |
| JEL: | L |
| Date: | 2005–12–19 |
| URL: | http://d.repec.org/n?u=RePEc:wpa:wuwpio:0512011&r=upt |