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on Utility Models and Prospect Theories |
| By: | P. VAN DE WEGHE; W. BRUGGEMAN |
| Abstract: | In this paper, an experiment was conducted in a multidimensional environment to examine the incentive framing effectiveness under conditions of uncertainty, as opposed to certainty. Whereas previous research generally has treated uncertainty as an indivisible concept, this paper proposes a framework from which it is clear that several sources of uncertainty exist, each influencing a different part of the proposed effort-outcome relationship. A comparison was made between certainty and uncertainty, stemming from uncontrollable factors respectively imperfect monitoring. The results indicate that it is valuable to use penalty-framed incentives under certainty conditions, and that performance is higher under certainty than under conditions with either source of uncertainty. The reason lies in a higher level of effort intensity and more efficient effort allocation. Furthermore, it seems that penalty schemes induce higher performance than bonuses under imperfect monitoring, while incentive framing has no effect under uncertainty stemming from uncontrollable factors. The latter results, under uncertainty conditions, can be explained by differences in risk attitude and perceived risk. |
| Date: | 2006–07 |
| URL: | http://d.repec.org/n?u=RePEc:rug:rugwps:06/399&r=upt |
| By: | Marie-Louise Vierø (Department of Economics, Queen's University) |
| Abstract: | This paper derives a representation of preferences for a choice theory with vague environments; vague in the sense that the agent does not know the precise probability distributions over outcomes conditional on states. Instead, he knows only a possible set of these probabilities for each state. Thus, the paper relaxes an assumption about the environment, which is done while maintaining the independence axiom. The behavior implied by this model is different from both the behavior implied by standard subjective expected utility models and the behavior implied by ambiguity aversion models. To illustrate these differences and the importance of allowing for vagueness, the consequences of the developed theory for a simple contracting problem are considered. The paper also provides a defense of the independence axiom against the usual Ellsberg critique. |
| Keywords: | Decision Theory, Vagueness, Utility, Optimism, Positivism |
| JEL: | D80 D81 D00 |
| Date: | 2006–10 |
| URL: | http://d.repec.org/n?u=RePEc:qed:wpaper:1094&r=upt |
| By: | White, Lucy |
| Abstract: | We investigate the outcome of bargaining when a player’s pay-off from agreement is risky. We find that a risk-averse player typically increases his equilibrium receipts when his pay-off is made risky. This is because the presence of risk makes individuals behave 'more patiently' in bargaining. Strong analogies are drawn to the precautionary saving literature. We show that the effect of risk on receipts can be sufficiently strong that a decreasingly risk-averse player may be better off receiving a risky pay-off than a certain pay-off. |
| Keywords: | Nash bargaining; prudence; risk aversion; Rubinstein bargaining |
| JEL: | C71 C72 C78 D80 |
| Date: | 2006–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5822&r=upt |
| By: | De Giorgi, Enrico (Institute of Finance, University of Lugano); Hens, Thorsten (Institute for Empirical Research in Economics, University of Zurich) |
| Abstract: | This paper gives a survey over a common aspect of prospect theory that occurred to be of importance in a series of recent papers developed by Enrico De Giorgi, Thorsten Hens, Janos Mayer, Haim Levy, Thierry Post, Marc Oliver Rieger and Mei Wang. The common aspect of these papers is that the value function of the prospect theory of Kahneman and Tversky (1979) and similarly that of Tversky and Kahneman (1992) has to be re-modelled if one wants to apply it to portfolio selection. Instead of the piecewise power value function, a piecewise negative exponential function should be used. This functional form is still compatible with laboratory experiments but it has the following advantages over and above Kahneman and Tversky`s piecewise power function: <p> 1. The Bernoulli Paradox does not arise for lotteries with finite expected value. <p> 2. No infinite leverage/robustness problem arises. <p> 3. CAPM-equilibria with heterogeneous investors and prospect utility do exist. <p> 4. It is able to simultaneously resolve the following asset pricing puzzles: the equity premium, the value and the size puzzle. |
| Keywords: | Prospect theory; portfolio selection |
| JEL: | G00 |
| Date: | 2005–12–22 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:nhhfms:2005_019&r=upt |
| By: | Alfredo Di Tillio |
| Abstract: | This paper extends Savage’s subjective approach to probability and utility from decision problems under exogenous uncertainty to choice in strategic environments. Interactive uncertainty is modeled both explicitly — using hierarchies of preference relations, the analogue of beliefs hierarchies — and implicitly — using preference structures, the analogue of type spaces à la Harsanyi — and it is shown that the two approaches are equivalent. Preference structures can be seen as those sets of hierarchies arising when certain restrictions on preferences, along with the players’ common certainty of the restrictions, are imposed. Preferences are a priori assumed to satisfy only very mild properties (reflexivity, transitivity, and monotone continuity). Thus, the results provide a framework for the analysis of behavior in games under essentially any axiomatic structure. An explicit characterization is given for Savage’s axioms, and it is shown that a hierarchy of relatively simple preference relations uniquely identifies the decision maker’s utilities and beliefs of all orders. Connections with the literature on beliefs hierarchies and correlated equilibria are discussed. |
| URL: | http://d.repec.org/n?u=RePEc:igi:igierp:311&r=upt |
| By: | Thomas Dohmen (IZA Bonn); Armin Falk (IZA Bonn, University of Bonn, and CEPR); David Huffman (IZA Bonn); Uwe Sunde (IZA Bonn, University of Bonn, and CEPR) |
| Abstract: | We investigate whether two crucial determinants of economic decision making – willingness to take risks and willingness to trust other people – are transmitted from parents to children. Our evidence is based on survey questions that ask about these attitudes directly, and are good measures in the sense that they reliably predict actual risk-taking and trusting behavior in large-scale, incentive compatible field experiments. We find a strong, significant, and robust correlation between the responses of parents and their children. Exploring heterogeneity in the strength of transmission, we find that gender of the child does not matter, but that children with fewer siblings, and firstborn children, are more strongly influenced by parents in terms of risk attitudes. Interestingly, for trust there is no impact of family size or birth order. There is some evidence of ‘receptive’ types: children who are similar to the father are similar to the mother, and children who are similar to parents in terms of risk are similar in terms of trust. We find that the transmission from parents to children is relatively specific, judging by questions that ask about willingness to take risks in specific contexts – financial matters, health, career, car driving, and leisure activities. Finally, we provide evidence of positive assortative mating based on risk and trust attitudes, which reinforces the impact of parents on children. Our results have potentially important implications for understanding the mechanisms underlying cultural transmission, social mobility, and persistent differences in behavior across countries. More generally, our findings shed light on the basic question of where attitudes towards risk and trust come from. |
| Keywords: | risk preferences, trust, intergenerational transmission, cultural transmission, assortative mating, social mobility, GSOEP |
| JEL: | D1 D8 J12 J13 J62 Z13 |
| Date: | 2006–10 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp2380&r=upt |
| By: | Brodaty, Thomas; Gary-Bobo, Robert J.; Prieto, Ana |
| Abstract: | We propose to model individual educational investments as a rational decision, maximizing expected utility, conditional on some characteristics observed by the student, under the combined risks affecting future wages and schooling duration. Assuming that students' attitudes toward risk can be represented by a CRRA utility, we show that the risk-aversion parameter can be identified in a natural way, using the variation in school-leaving ages, conditional on certified educational levels. Estimation can be performed by means of classic Maximum Likelihood methods. The model can easily be compared with a non-structural, simplified version, which is a standard wage equation with endogenous dummy variables representing education levels, education levels being themselves determined by an Ordered Probit model. We find small but significant values of the coefficient of relative risk aversion, between 0.1 and 0.9. These results are obtained with a rich sample of 12,500 young men who left the educational system in 1992, in France. |
| Keywords: | econometrics; human capital; returns to education; risk aversion |
| JEL: | I2 J24 J31 |
| Date: | 2006–06 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5694&r=upt |
| By: | Hens, Thorsten (Institute for Empirical Research in Economics, University of Zurich); Vlcek, Martin (Institute for Empirical Research in Economics, University of Zurich) |
| Abstract: | The disposition effect 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 first 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: | G11 |
| Date: | 2005–12–22 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:nhhfms:2005_018&r=upt |
| By: | Ågren, Martin (Department of Economics) |
| Abstract: | The paper relates cumulative prospect theory to the moments of returns distributions, e.g. skewness and kurtosis, assuming returns are normal inverse Gaussian distributed. The normal inverse Gaussian distribution parametrizes the first- to forth-order moments, making the investigation straightforward. Cumulative prospect theory utility is found to be positively related to the skewness. However, the relation is negative when probability weighing is set aside. This shows that cumulative prospect theory investors display a preference for skewness through the probability weighting function. Furthermore, the investor’s utility is inverse hump-shape related to the kurtosis. Consequences for portfolio choice issues are studied. The findings, among others, suggest that optimal cumulative prospect theory portfolios are not meanvariance efficient under the normal inverse Gaussian distribution. |
| Keywords: | cumulative prospect theory; skewness; kurtosis; normal inverse Gaussian distribution; portfolio choice |
| JEL: | C16 D81 G11 |
| Date: | 2006–10–17 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:uunewp:2006_024&r=upt |
| By: | Gerber, Anke (Institute for Empirical Research in Economics, University of Zurich); Hens, Thorsten (Institute for Empirical Research in Economics, University of Zurich); Woehrmann, Peter (Institute for Empirical Research in Economics, University of Zurich) |
| Abstract: | We consider a dynamic general equilibrium model with incomplete markets in which we derive conditions for separating the savings decision from the asset allocation decision. It is shown that with logarithmic utility functions this separation holds for any heterogeneity of discount factors while the generalization to constant relative risk aversion only holds for homogeneous discount factors. Our results have simple asset pricing implications for the time series and also the cross section of asset prices. It is found that on data from the DJIA a risk aversion weaker than in the logarithmic case fits best. |
| Keywords: | Dynamic general equilibrium model; asset pricing |
| JEL: | D50 |
| Date: | 2005–12–22 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:nhhfms:2005_016&r=upt |
| By: | Paul Preckel; Thomas Hertel (Department of Agricultural Economics, College of Agriculture, Purdue University); John Cranfield |
| Abstract: | The CES is generalized by extension of the work of Hanoch (1975) resulting in implicit, direct and indirect relationships between utility and consumption. Expressions for substitution and income elasticities are developed and observed to be variable, rather than constant as in the CES case. |
| Keywords: | Constant elasticity of substitution, implicit functions, preferences, demand |
| JEL: | D12 D21 |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:pae:wpaper:05-03&r=upt |
| By: | Døskeland, Trond M. (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration); Nordahl, Helge A. (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration) |
| Abstract: | In this paper we provide a framework for how the traditional life and pension contracts with a guaranteed rate of return can be optimized to increase customers’ welfare. Given that the contracts have to be priced correctly, we use individuals’ preferences to find the preferred design. Assuming CRRA utility, we cannot explain the existence of any form of guarantees. Through numerical solutions we quantify the difference (measured in security equivalents) to the preferred Merton solution of direct investments in a fixed proportion of risky and risk free assets. The largest welfare loss seems to come from the fact that guarantees are effective by the end of each year, not only by the expiry of the contract. However, the demand for products with guarantees may be explained through behavioral models accounting for loss aversion, e.g. cumulative prospect theory. In this case, the optimal design seems to be a simple contract with a life-time guarantee. |
| Keywords: | Household Finance; Portfolio Choice; Life and Pension Insurance; Prospect Theory |
| JEL: | G11 G13 G22 |
| Date: | 2006–10–18 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:nhhfms:2006_014&r=upt |
| By: | Adrien Verdelhan (Department of Economics, Boston University); |
| Abstract: | This paper presents a fully rational general equilibrium model that produces a time-varying exchange rate risk premium and solves the uncovered interest rate parity puzzle. In this two-country model, agents are characterized by slow-moving external habit preferences similar to Campbell & Cochrane (1999) and they incur proportional and quadratic international trade costs. The domestic investor receives a positive exchange rate risk premium when she is effectively more risk-averse than her foreign counterpart. Times of high risk-aversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. |
| Keywords: | Exchange rate, Time-varying risk premium, Habits. |
| JEL: | F31 G12 G15 |
| Date: | 2006–03 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2006-042&r=upt |
| By: | Singh Bhamra, Harjoat; Uppal, Raman |
| Abstract: | We study the effect of introducing a new security, such as a non-redundant derivative, on the volatility of stock-market returns. Our analysis uses a standard, continuous time, dynamic, general-equilibrium, full-information, frictionless, Lucas endowment economy where there are two classes of agents who have time-additive power utility functions and differ only in their risk aversion. We solve for equilibrium in two versions of this economy. In the first version, risk-sharing opportunities are limited because investors can trade in only the market portfolio, which is a claim on the aggregate endowment. In the second version, agents can trade in both the market portfolio and a new zero-net-supply derivative. We show analytically that for a sufficiently small precautionary-savings effect, the introduction of a non-redundant derivative on the market increases the volatility of stock-market returns. |
| Keywords: | general equilibrium; options; risk-sharing; volatility |
| JEL: | G12 G13 |
| Date: | 2006–06 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5726&r=upt |
| By: | Staffiero, Gianandrea (IESE Business School) |
| Abstract: | We present an explanation of the high frequency of team production and high level of peer monitoring found in Japanese firms, in terms of a simple and empirically grounded variation in individual utility functions. We argue that Japanese agents are generally characterized by a higher degree, with respect to their Western counterparts, of aversion to unfavorable inequality, a feature which explains seemingly puzzling experimental evidence. In combination with long term employment and various organizational practices, this creates the conditions for obtaining willingness to exert mutual monitoring and peer pressure which facilitates the convergence towards cooperative equilibria in dilemma type situations. |
| Keywords: | Team Production; Fairness; Cooperation; Punishment; Reciprocity; |
| JEL: | C91 C92 D63 H41 L23 |
| Date: | 2006–09–05 |
| URL: | http://d.repec.org/n?u=RePEc:ebg:iesewp:d-0645&r=upt |
| By: | Marius Valentin Boldea (Panthéon-Sorbonne Economie) |
| Abstract: | In this paper I study a discrete-time version of the Lucas model with the endogenous leisure but without physical capital. Under standard conditions I prove that the optimal human capital sequence is increasing. If the instantaneous utility function and the production function are Cobb-Douglas, I prove that the human capital sequence grow at a constant rate. I finish by studying the existence and the unicity of the equilibrium in the sense of Lucas or Romer. |
| Keywords: | Lucas Model, human capital, externalities, optimal growth, equilibrium. |
| Date: | 2006–07 |
| URL: | http://d.repec.org/n?u=RePEc:mse:wpsorb:b06054&r=upt |
| By: | Steve Cassou (Kansas State University); Arantza Gorostiaga (Universidad del País Vasco / The University of the Basque Country); María José Gutiérrez (Universidad del País Vasco / The University of the Basque Country); Stephen Hamilton (CAL POLY STATE UNIVERSITY, SAN LUIS OBISPO) |
| Abstract: | This paper investigates the exploitation of environmental resources in a growing economy within a second-best scal policy framework. Agents derive utility from two types of consumption goods one which relies on an environmental input and one which does not as well as from leisure and from environmental amenity values. Property rights for the environmental resource are potentially incomplete. We connect second best policy to essential components of utility by considering the elasticity of substitution among each of the four utility arguments. The results illustrate potentially important relationships between environmental amentity values and leisure. When amenity values are complementary with leisure, for instance when environmental amenities are used for recreation, taxes on extractive goods generally increase over time. On the other hand, optimal taxes on extractive goods generally decrease over time when leisure and environmental amenity values are substitutes. Unders some parameterizations, complex dynamics leading to nonmonotonic time paths for the state variables can emerge. |
| Keywords: | Growth and the environment; Elasticity of substitution; Second-best policy |
| JEL: | H23 O41 Q28 |
| Date: | 2006–10–16 |
| URL: | http://d.repec.org/n?u=RePEc:ehu:dfaeii:200603&r=upt |
| By: | De Giorgi, Enrico (Institute of Finance, University of Lugano); Hens, Thorsten (Institute for Empirical Research in Economics, University of Zurich); Post, Thierry (Erasmus School of Economics, Erasmus University of Rotterdam) |
| Abstract: | Using canonical data for the US stock and bond markets, we show that the kinked piecewise exponential value function can rationalize the cross-section of stock returns in addition to the level of the equity premium, while the kinked piecewise-power value function of Tversky and Kahneman can explain only the latter. |
| Keywords: | Prospect Theory; Premium Puzzles |
| JEL: | G00 |
| Date: | 2005–12–22 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:nhhfms:2005_020&r=upt |
| By: | Oussama Chakroun; Georges Dionne; Amélie Dugas-Sampara |
| Abstract: | We examine the portfolio-choice puzzle posed by Canner, Mankiw, and Weil (1997). The idea is to test a conclusion reached by Elton and Gruber (2000), stating that a bonds/stocks ratio which decreases in relation to risk tolerance does not necessarily mean a contradiction of modern portfolio-choice theory and does not cast doubt on the rationality of investors. From data on the portfolio composition of 470 clients of a Canadian brokerage firm, we obtain that the bonds/stocks ratio does decrease in relation to risk tolerance. We also verify the existence of the two-fund separation theorem in the assets data available to the investors in our sample. |
| Keywords: | Investor rationality, asset allocation puzzle, risk tolerance, separation theorem, bonds/stocks ratio |
| JEL: | C13 D12 D80 G11 G23 |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:lvl:lacicr:0635&r=upt |
| By: | Jawwad Noor (Department of Economics, Boston University) |
| Abstract: | Due to factors such as temptation, choices may not respect normative prefer- ence (the agent.s own, subjective view of what constitutes his welfare). Neverthe- less, the evidence on preference reversals suggests a means of recovering normative preference from choice. A de.nition of normative preference in terms of choices between su¢ ciently delayed alternatives is formulated and studied. Mild condi- tions on behavior are shown to ensure the existence of a normative preference. Two characterizations are provided. It is demonstrated that a notion of welfare may exist inspite of dynamic inconsistency of preferences. An application shows that the evidence on hyperbolic discounting implies that agents.normative discount functions must be exponential. |
| Keywords: | Preference Reversals, Welfare, Temptation, Hyperbolic Discount- ing, Ethics. |
| JEL: | D11 |
| Date: | 2005–10 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2005-039&r=upt |