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on Utility Models and Prospect Theories |
| By: | Ulrich Schmidt (Lehrstuhl fuer Finanzmarkttheorie, Universitaet Hannover); Chris Starmer (School of Economics, University of Nottingham); Robert Sugden (School of Economic and Social Studies, University of East Anglia) |
| Abstract: | We present a new theory of decision under risk called third-generation prospect theory. A novel feature of our version of prospect theory is that, by allowing reference points to be uncertain, it is able to accommodate the phenomenon of preference reversal. While several previous theories of preference reversal have been proposed, thus far it has resisted explanation via any empirically plausible model of preferences. We investigate whether our explanation is empirically plausible. We find that the standard patterns of preference reversal are predicted for typical parameterisations of prospect theory already established in the empirical literature. Consequently we suggest that our model constitutes a best buy theory: it offers the predictive power of previous variants of prospect theory and adds to that an explanation of preference reversal. The latter comes ‘free of charge’ since it involves no extra parameters and no re-parameterisation. |
| Keywords: | Prospect theory, preference reversal, reference dependence |
| JEL: | D81 |
| Date: | 2005–04 |
| URL: | http://d.repec.org/n?u=RePEc:cdx:dpaper:2005-19&r=upt |
| By: | Thorsten Hens; Martin Vlcek |
| Abstract: | The disposition eect is the observation that investors hold winning stocks too long and sell losing stocks too early. A standard explanation of the disposition effect refers to prospect theory and in particular to the asymmetric risk aversion according to which investors are risk averse when faced with gains and risk-seeking when faced with losses. We show that for reasonable parameter values the disposition effect can however not be explained by prospect theory as proposed by Kahneman and Tversky. The reason is that those investors who sell winning stocks and hold loosing assets would in the rst place not have invested in stocks. That is to say the standard prospect theory argument is sound ex-post, assuming that the investment has taken place, but not ex-ante, requiring that the investment is made in the first place. |
| Keywords: | Disposition effect, prospect theory, portfolio choice |
| JEL: | C91 |
| Date: | 2006–01 |
| URL: | http://d.repec.org/n?u=RePEc:zur:iewwpx:262&r=upt |
| By: | Floris Heukelom (Faculty of Economics, Universiteit van Amsterdam) |
| Abstract: | The origin of prospect theory is the desire to test the intuitive statistician in the real world. The development of this theory by the cognitive psychologists Kahneman and Tversky can be traced to the formers work in cognitive psychophysics, in which deviations from average behavior are termed (statistical) errors; and the latters work on decision theory, with its normative vs. descriptive framework. The combination of these two types of probabilistic psychology culminated in a new descriptive theory of human decision making in the real world, coined Heuristics and Biases. The 1979 Econometrica article applies this new descriptive theory to economists EUT. It equates the intuitive statistician with the rational economic man and shows how it descriptively fails. |
| Keywords: | Kahneman and Tversky; Prospect Theory; Intuitive Statistician; Heuristics and Biases |
| JEL: | B31 B41 D81 |
| Date: | 2005–12–08 |
| URL: | http://d.repec.org/n?u=RePEc:dgr:uvatin:20050111&r=upt |
| By: | Alexander Harin (Modern University for the Humanities) |
| Abstract: | This is a paper in honor of EconWPA and of those who have supported it. The role of EconWPA in creating and developing the feasible future scientific revolution in one or more fields of economic theory is reviewed. |
| Keywords: | scientific revolution, scientific evolution, bank, market, industry, development, investment, risk |
| JEL: | C D E G C7 D81 |
| Date: | 2005–12–31 |
| URL: | http://d.repec.org/n?u=RePEc:wpa:wuwpmh:0512003&r=upt |
| By: | Robin Cubitt (School of Economics, University of Nottingham); Robert Sugden (School of Economics, University of East Anglia) |
| Abstract: | The game-theoretic assumption of ‘common knowledge of rationality’ leads to paradoxes when rationality is represented in a Bayesian framework as cautious expected utility maximization with independent beliefs (ICEU). We diagnose and resolve these paradoxes by presenting a new class of formal models of players’ reasoning in which the analogue of common knowledge is provability in common reason. We show that a range of standards of decision-theoretic practical rationality can be assumed without inconsistency to be provable in common reason in models of this class. We investigate the implications arising when the standard of decision-theoretic rationality so assumed is ICEU. |
| JEL: | C72 |
| Date: | 2005–09 |
| URL: | http://d.repec.org/n?u=RePEc:cdx:dpaper:2005-17&r=upt |
| By: | Glenn Harrison (Department of Economics, College of Business Administration, University of Central Florida); Steven Humphrey (School of Economics, University of Nottingham); Arjan Verschoor (School of Development Studies, University of East Anglia) |
| Abstract: | We review experimental evidence collected from risky choice experiments using poor subjects in Ethiopia, India and Uganda. Using these data we estimate that just over 50% of our sample behaves in accordance with expected utility theory and that the rest subjectively weight probability according to prospect theory. Our results show that inferences about risk aversion are robust to whichever model we adopt when we estimate each model separately. However, when we allow both models to explain portions of the data simultaneously, we infer risk aversion for subjects behaving according to expected utility theory and risk seeking behavior for subjects behaving according to prospect theory. We conclude that the current practice of designing policies under the assumption that one or other explains all behavior is fundamentally flawed. |
| Keywords: | choice under uncertainty, field experiments, developing countries |
| JEL: | O12 D81 C93 |
| Date: | 2005–10 |
| URL: | http://d.repec.org/n?u=RePEc:cdx:dpaper:2005-18&r=upt |
| By: | Yann Rébillé (CERMSEM) |
| Abstract: | Since von Neuman and Morgenstern's (1944) contribution to game theory, a rational decision maker will rank risky prospects according to the celebrated Expected utility criterion. This method takes lotteries i.e. (simple) probability distributions to represent risky prospects. If the decision maker follows the vN-M axioms (e.g.Kreps (1988)) then there exists a utility function such that any probability can be resumed to a lottery having for support the best and the worst state, where the probability that he wins the bet is given by its expected utility. Probalities are precise objects to model risk, but the way they do it is incoherent (Dubois and Prade (1988)). A familiar object in fuzzy set theory is the one of necessity or its dual version a possibility. In which case the occurence of an event is given by an interval which expresses the imprecision. Nevertheless the description of risk is coherent. Our concern is to rank different necessity measures and rank them according to the Choquet Expectation criterion (Choquet (1953)). If the decision maker follows our set of axioms then there exists a fuzzy set (Zadeh (1978)) such that any necessity can be resumed to a bet on being perfectly informed of the state which occurs or being totally ignorant, where the degree of information he will get is given by its Choquet expectation. |
| Keywords: | Non-additive measures, possibility theory, expected utility. |
| JEL: | D81 |
| Date: | 2005–12 |
| URL: | http://d.repec.org/n?u=RePEc:mse:wpsorb:b05088&r=upt |
| By: | Yann Rébillé (CERMSEM) |
| Abstract: | Since von Neuman and Morgenstern's (1944) contribution to game theory, the expected utility criterion has become the standard functional to evaluate risky prospects. Risky prospects are understood to be lotteries on a set of prizes. In which case a decision maker will receive a precise prize with a given probability. A wide interest on imprecise object has been developped since Zadeh's (1978) contribution to artificial intelligence, through the use of possibility function (see Dubois Prade (1988)). In this setting a decision maker is uncertain about the precise features of the object he is dealing with. A first step has been readily made to rank imprecise objects in Rébillé (2005). Our objective is to build a decision theory which deals with imprecise lotteries i.e. lotteries on imprecise prizes, a typical situation encountered in Ellsberg's experiment (1961). |
| Keywords: | Non-additive measures, possibility theory, Choquet integral, decision making. |
| JEL: | D81 |
| Date: | 2005–12 |
| URL: | http://d.repec.org/n?u=RePEc:mse:wpsorb:b05089&r=upt |
| By: | Vincenzo Merella (School of Economics, Mathematics & Statistics, Birkbeck College); Steve Satchell (School of Economics, Mathematics & Statistics, Birkbeck College) |
| Abstract: | An omitted variable in the household's preferences specification may lead to overestimate the volatility of consumption, or alternatively to overvalue the risk aversion coefficient required to match the equity premium. This paper proposes to augment the utility function by adding a nontradable variable that is not under the consumer's direct control. We regard this variable as reflecting additional information on the household optimizing behaviour, and suggest two measures of consumer confidence as proxies for it. We find that the new specification of preferences eliminates the equity premium puzzle. In addition, we argue that the standard assumption of joint log-normality may not be supported by empirical evidence. |
| Date: | 2005–12 |
| URL: | http://d.repec.org/n?u=RePEc:bbk:bbkefp:0525&r=upt |
| By: | W. Kip Viscusi |
| Abstract: | This paper provides a systematic review of the economic analysis of health, safety, and environmental regulations. Although the market failures that give rise to a rationale for intervention are well known, not all market failures imply that market risk levels are too great. Hazard warnings policies often can address informational failures. Some market failures may be exacerbated by government policies, particularly those embodying conservative risk assessment practices. Labor market estimates of the value of statistical life provide a useful reference point for the efficient risk tradeoffs for government regulation. Guided by restrictive legislative mandates, regulatory policies often strike a quite different balance with an inordinately high cost per life saved. The risk-risk analysis methodology enables analysts to assess the net safety implications of policy efforts. Inadequate regulatory enforcement and behavioral responses to regulation may limit their effectiveness, while rising societal wealth will continue to generate greater levels of health and safety. |
| JEL: | K32 Q2 J28 J17 |
| Date: | 2006–01 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:11934&r=upt |
| By: | Robin Cubitt (School of Economics, University of Nottingham); Maria Ruiz-Martos (School of Economics, University of Nottingham); Chris Starmer (School of Economics, University of Nottingham) |
| Abstract: | The paper reports an experiment which tests the principle of separability, i.e. that behaviour in a dynamic choice problem is independent of history and of unreachable eventualities. Although this is a standard principle of decision theory, it can be questioned on grounds suggested by non-expected utility models of choice under risk and by the psychology of affective influences on risk-taking. Our experimental design, which provides between-subjects tests of separability using three treatments in which the history preceding a decision is manipulated, is inspired by these concerns. But, we find no significant evidence of violation of separability. |
| Keywords: | Separability; history-independence; non-expected utility; risk and affect |
| Date: | 2005–11 |
| URL: | http://d.repec.org/n?u=RePEc:cdx:dpaper:2005-21&r=upt |
| By: | Michihiro Kandori; Roberto Serrano; Oscar Volij |
| Abstract: | We study decentralized trade processes in general exchange economies and house allocation problems with and without money. The processes are subject to persistent random shocks stemming from agents’ maximization of random utility. By imposing structure on the utility noise term —logit distribution—, one is able to calculate exactly the stationary distribution of the perturbed Markov process for any level of noise. We show that the stationary distribution places the largest probability on the maximizers of weighted sums of the agents’ (intrinsic) utilities, and this probability tends to 1 as noise vanishes |
| Date: | 2005–11 |
| URL: | http://d.repec.org/n?u=RePEc:cte:werepe:we056433&r=upt |
| By: | Kenjiro Hori (School of Economics, Mathematics & Statistics, Birkbeck College) |
| Abstract: | This paper analyses the optimal wage contract when firms face demand uncertainty and workers care about employment stability. Workers choose the firm that offers the highest utility taking into account the future lay-off probabilities; firms choose the wage contract that maximises the residual share of the gains from production. For risk-neutral workers this occurs with any efficient wage contract so long as it matches the ex-ante outside option of the workers, i.e. all feasible efficient contracts are optimal. The feasibility is proved for the efficient profit-sharing case. For risk-averse workers with variable effort supply, profit-sharing contracts are further shown to provide effort incentives through both their efficiency wage and performance-related payout effects. The paper thus promotes profit-sharing contracts not only on the grounds of employment stability, but also on the basis of its efficiency and incentive effects. |
| Keywords: | feasiblity, optimal wage contract, profit-share, efficiency |
| JEL: | J33 J23 |
| Date: | 2006–01 |
| URL: | http://d.repec.org/n?u=RePEc:bbk:bbkefp:0601&r=upt |
| By: | Bennardo, Alberto; Piccolo, Salvatore |
| Abstract: | We study a general equilibrium model where agents' preferences, productivity and labour endowments depend on their health status, and occupational choices affect individual health distributions. Efficiency typically requires agents of the same type to obtain different expected utilities if assigned to different occupations. Under mild assumptions, workers with riskier jobs must get higher expected utilities if health aspects production capabilities. The same holds if health aspects preferences and health enhancing consumption activities are sufficiently effective, so that income and health are substitutes. The converse obtains when health aspects preferences, but health enhancing consumption activities are not very effective, and hence income and health are complements. Competitive equilibria are first- best if lottery contracts are enforceable, but typically not if only assets with deterministic payoffs are traded. Compensating wage differentials which equalize the utilities of workers in different jobs are incompatible with ex-ante efficiency. Finally, absent asymmetric information, there exist deterministic cross-jobs transfers leading to ex-ante efficiency. |
| Keywords: | compensating wage differentials; competitive markets; individual health risks; Pareto efficiency |
| JEL: | D5 D61 D80 I18 |
| Date: | 2005–12 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5385&r=upt |
| By: | Claude, d’ASPREMONT (UNIVERSITE CATHOLIQUE DE LOUVAIN, Department of Economics) |
| Abstract: | The formulation of the problem of justice among generations as the problem of finding an ordering of infinite utility streams is examined within the ‘social welfare functional’ approach to social choice. This formulation usually presumes a double reduction not only the classical ‘welfarist’ reduction, according to which ‘utility’ provides all the information required to construct a social evaluation rule, but also the aggregation of the individual utility levels at each generation into a single utility level. We shall argue that this second type of reduction obliterates the relationship between the values judgments made in the social evaluation of the welfare of the presently living generation with that of future generations and does not emphasize the capacity for many social evaluation criteria (including pure utilitarianism and Leximin) to ’proliferate’ from the present generation to any larger set of generations. Our results concerning the orderings generated by such proliferating rules are compared to characterisations already given in the literature. |
| Date: | 2005–11–15 |
| URL: | http://d.repec.org/n?u=RePEc:ctl:louvec:2005051&r=upt |
| By: | Andrew Postlewaite (Department of Economics, University of Pennsylvania); Larry Samuelson (Department of Economics, University of Wisconsin-Madison); Dan Silverman (Department of Economics, University of Michigan) |
| Abstract: | We examine an economy in which the cost of consuming some goods can be reduced by making commitments that reduce flexibility. We show that such consumption commitments can induce consumers with risk-neutral underlying utility functions to be risk averse over small variations in income, but sometimes to seek risk over large variations. As a result, optimal employment contracts will smooth wages conditional on being employed, but may incorporate a possibility of unemployment. |
| Keywords: | Unemployment, consumption commitments, optimal contracts |
| JEL: | D21 D31 D81 |
| Date: | 2001–12–01 |
| URL: | http://d.repec.org/n?u=RePEc:pen:papers:06-002&r=upt |
| By: | Xavier Ragot |
| Abstract: | The article presents a new channel through which inflation affects real variables. In a simple liquidity constraint model where money enters the utility function of infinitely living households, it is proven that credit constraints create heterogeneity in money demand. Because of this, long run inflation affects the real interest rate and wealth inequalities even when there is no redistributive effect, no distorting fiscal policy, and no substitution between leisure and working time. This result is proven for a general class of utility and production functions. In a simple calibration exercise, an increase in inflation from 2% to 3% increases the capital stock by 0.12% and raises wealth inequality. |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:pse:psecon:2005-51&r=upt |
| By: | Filippo Occhino (Rutgers University) |
| Abstract: | How should taxes, government expenditures, the primary and fiscal surpluses and government liabilities be set over the business cycle? We assume that the government chooses expenditures and taxes to maximize the utility of a representative household, utility is increasing in government expenditures, only distortionary labor income taxes are available, and the cycle is driven by exogenous technology shocks. We first consider the commitment case, and characterize the Ramsey equilibrium. In the case that the utility function is constant elasticity of substitution between private and public consumption and separable between the composite consumption good and leisure, taxes, government expenditures and the primary surplus should all be constant positive fractions of production, and both government liabilities and the fiscal surplus should be positively correlated with production. Then, we relax the commitment assumption, and we show how to determine numerically whether the Ramsey equilibrium can be sustained by the threat to revert to a Markov perfect equilibrium. We find that, for realistic values of the preferences discount factor, the Ramsey equilibrium is sustainable. |
| Keywords: | Fiscal Policy; Commitment; Ramsey Equilibrium; Time-consistency; Sustainable equilibrium; |
| JEL: | E62 |
| Date: | 2005–05–05 |
| URL: | http://d.repec.org/n?u=RePEc:rut:rutres:200502&r=upt |
| By: | Nicoletta Batini (International Monetary Fund); Alejandro Justiniano (International Monetary Fund); Paul Levine (University of Surrey); Joseph Pearlman (London Metropolitan University) |
| Abstract: | This paper provides a first attempt to quantify and at the same time utilize estimated measures of uncertainty for the design of robust interest rate rules. We estimate several variants of a linearized form of a New Keynesian model using quarterly US data. Both our theoretical and numerical results indicate that Inflation-Forecast-Based (IFB) rules are increasingly prone to the problem of indeterminacy as the forward horizon increases. As a consequence the stabilization performance of optimized rules of this type worsens too. Robust IFB rules can be designed to avoid indeterminacy in an uncertain environment, but at an increasing utility loss as rules become more forward-looking. |
| Keywords: | robustness, Taylor rules, inflation-forecast-based rules, indeterminacy |
| JEL: | E52 E37 E58 |
| Date: | 2004–09 |
| URL: | http://d.repec.org/n?u=RePEc:sur:surrec:0804&r=upt |
| By: | Qiu_Hong Wang (Department of Information Systems, National University of Singapore); Kai-Lung Hui (Department of Information Systems, 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: | 2005–12–28 |
| URL: | http://d.repec.org/n?u=RePEc:wpa:wuwpio:0512013&r=upt |
| By: | Martin Hellwig (Max Planck Institute for Research on Collective Goods, Bonn) |
| Abstract: | For the standard specification of the utilitarian optimal income tax problem with hidden characteristics, the paper shows that randomized tax schemes are undesirable if preferences exhibit a property of weakly decreasing risk aversion according to the multidimensional risk aversion concept of Hellwig (2004). The property of decreasing risk aversion also implies uniqueness of the optimal income tax schedule and continuity in cases where the type distribution has a continuous density. |
| Keywords: | Optimal Income Taxation, Randomized Incentive Schemes, Nonincreasing Risk Aversion |
| JEL: | H21 |
| Date: | 2005–12 |
| URL: | http://d.repec.org/n?u=RePEc:mpg:wpaper:2005_27&r=upt |
| By: | Smith, V. Kerry; Banzhaf, H. Spencer (Resources For the Future) |
| Abstract: | We document the sensitivity of welfare estimates derived from discrete choice models to assumptions about the choice set. Such assumptions can affect welfare estimates through both the estimated parameters of the model and, conditional on the parameters, the substitution among alternatives. Our analysis involves estimates of the benefits of air quality improvements in Los Angeles based on discrete choices of neighborhood and housing. We further illustrate the use of meta analysis to document and summarize voluminous information derived from repeated sensitivity analyses. |
| Keywords: | Meta analysis, random utility model, choice set, air quality, housing |
| JEL: | C15 Q25 R21 |
| URL: | http://d.repec.org/n?u=RePEc:rff:dpaper:dp-03-61&r=upt |
| By: | Smith, V. Kerry; Von Haefen, Roger |
| Abstract: | This paper generalizes results from Anderson, De Palma, and Thisse [1992] linking individual random utility and aggregate representative individual demand models, to consider a comparable relation for the willingness to pay functions for quality attributes of marketed goods. It also suggests how the logic can be used to describe links between choice occasion and aggregate models (across occasions) for an individual. |
| URL: | http://d.repec.org/n?u=RePEc:rff:dpaper:dp-97-32&r=upt |
| By: | Fischer, Carolyn (Resources For the Future) |
| Abstract: | A model of time-consistent procrastination is developed to assess the extent to which the observed behavior is compatible with rational behavior. When a finite work requirement must be completed by a deadline, the remaining time for leisure is an exhaustible resource. With a positive rate of time preference, the optimal allocation of this resource results in more hours spent working (and fewer in leisure) the closer the deadline. Key qualitative findings of psychological studies of academic procrastination are consistent with the standard natural resource management principles implied by the model, when suitably adapted to task aversiveness, uncertainty, and multiple deadlines. However, quantitatively, the fully rational model requires an extremely high rate of time preference or elasticity of intertemporal substitution to generate serious procrastination; furthermore, it cannot explain undesired procrastination. A companion paper, "Read This Paper Even Later- Procrastination with Time-Inconsistent Preferences" analyzes the extent to which alternative time discounting preferences can better explain such impatience and address the issue of self-control failures. |
| URL: | http://d.repec.org/n?u=RePEc:rff:dpaper:dp-99-19&r=upt |