nep-upt New Economics Papers
on Utility Models and Prospect Theories
Issue of 2006‒11‒04
twelve papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Valuing Environmental Changes in the Presence of Risk: A Review and Discussion of Some Empirical Issues By W Shaw; Mary Riddell; Paul Jakus
  2. The Origin of Utility By De Fraja, Gianni
  3. Selection matters By Paolo Pin
  4. Sunspot Equilibria and the Transfer Paradox By Hens, Thorsten; Pilgrim, Beate
  5. Illiquid Assets and Optimal Portfolio Choice By Eduardo S. Schwartz; Claudio Tebaldi
  6. Can News About the Future Drive the Business Cycle? By Jaimovich, Nir; Rebelo, Sérgio
  7. Existence of Sunspot Equilibria and Uniqueness of Spot Market Equilibria: The Case of Intrinsically Complete Markets By Hens, Thorsten; Mayer, Janós; Pilgrim, Beate
  8. Equilibrium Yield Curves By Monika Piazzesi; Martin Schneider
  9. The Irrelevance of Market Incompleteness for the Price of Aggregate Risk By Dirk Krueger; Hanno Lustig
  10. Pension systems and the allocation of macroeconomic risk By Bovenberg,Lans; Uhlig,Harald
  11. The Existence and Persistence of a Winner’s Curse: Some Field Evidence By John D. Burger; Stephen J.K. Walters
  12. Initial Public Offerings of Ballplayers By John D. Burger; Richard D. Grayson; Stephen J.K. Walters

  1. By: W Shaw; Mary Riddell; Paul Jakus (Department of Economics, Utah State University)
    Abstract: The theory of ex-ante welfare measures is well establlished and has been addressed extensively in papers relating to the valuation of environmental resources when environmental variables have a random component. However, there have been many new developments in incorporating risks and uncertainty into economic models, and perhaps more importantly, there seems to be remaining confusion as to how to empirically implement such models. To date, a variety of estimation techniques have been utilized, with varying degrees of success in deriving an ex-ante welfare measure under risk. This manuscript assesses the state of the art by discussing the sources of risk, uncertainty, and error in utility models that incorporate risk. We are most interested in how to incorporate these ideas into empirical models and we examine how econometric estimation methods can best be used to obtain ex-ante welfare measures. We also present the current thinking on endogenous versus exogenous risks as well as subjective versus “expert” risk measures, and discuss some of the advantages and disadvantages likely to be encountered when using subjective-based risk estimates in empirical applications based on alternatives to the expected utility models.
    Date: 2005–02
  2. By: De Fraja, Gianni
    Abstract: This paper proposes an explanation for the universal human desire for increasing consumption. It holds that it was moulded in evolutionary times by a mechanism known to biologists as sexual selection, whereby a certain trait - observable consumption - is used by members of one sex to signal their unobservable characteristics valuable to members of the opposite sex. It then goes on to show that the standard economics problem of utility maximisation is formally equivalent to the standard biology problem of the maximisation of individual fitness, the ability to pass genes to future generations.
    Keywords: Darwin; natural selection; sexual selection; utility
    JEL: D63 I28
    Date: 2006–10
  3. By: Paolo Pin (Department of Applied Mathematics, University of Venice)
    Abstract: To test for the adaptive optimization of risk attitudes, we use a simple model of preferences among lotteries, where agents evolve with a Genetic Algorithm. We find that the genetic selection operator are fundamental in determining the outcomes of the simulations, along with the possibility of iterate choices in a single generation and an eventual factor of heritage across generations (all innocuous technical parameters at a first sight). Different choices of these mechanisms may easily lead to opposite behaviors, from risk aversion to even risk love. The simulations give a hint on the possible implications of the different selection operators, when trying to model the evolution of risk attitudes in different social and economic settings.
    Keywords: Risk preferences, genetic algorithm
    JEL: C61 D81
    Date: 2006–09
  4. By: Hens, Thorsten (Institute for Empirical Research in Economics, University of Zurich); Pilgrim, Beate (Reuters AG, Frankfurt, Germany)
    Abstract: We show that for international economies with two countries, in which agents have additively separable utility functions, the existence of sunspot equilibria is equivalent to the occurrence of the transfer paradox. This equivalence enables us to provide some new insights on the relation of the existence of sunspot equilibria and the multiplicity of spot market equilibria.
    Keywords: Sunspot Equilibria; Transfer Paradox
    JEL: C62 D52 F20 F30 O12
    Date: 2004–11–22
  5. By: Eduardo S. Schwartz; Claudio Tebaldi
    Abstract: The presence of illiquid assets, such as human wealth, housing and a proprietorship substantially complicates the problem of portfolio choice. This paper is concerned with the problem of optimal asset allocation and consumption in a continuous time model when one asset cannot be traded. This illiquid asset, which depends on an uninsurable source of risk, provides a liquid dividend. In the case of human capital we can think about this dividend as labor income. The agent is endowed with a given amount of the illiquid asset and with some liquid wealth which can be allocated in a market where there is a risky and a riskless asset. The main point of the paper is that the optimal allocations to the two liquid assets and consumption will critically depend on the endowment and characteristics of the illiquid asset, in addition to the preferences and to the liquid holdings held by the agent. We provide what we believe to be the first analytical solution to this problem when the agent has power utility of consumption and terminal wealth. We also derive the value that the agent assigns to the illiquid asset. The risk adjusted valuation procedure we develop can be used to value both liquid and illiquid assets, as well as contingent claims on those assets.
    JEL: G11
    Date: 2006–10
  6. By: Jaimovich, Nir; Rebelo, Sérgio
    Abstract: We propose a model that generates an economic expansion in response to good news about future total factor productivity (TFP) or investment-specific technical change. The model has three key elements: variable capital utilization, adjustment costs to investment, and preferences that exhibit a weak short-run wealth effect on the labour supply. These preferences nest the two classes of utility functions most widely used in the business cycle literature as special cases. Our model can generate recessions that resemble those of the post-war U.S. economy without relying on negative productivity shocks. The recessions are caused not by contemporaneous negative shocks but rather by lackluster news about future TFP or investment-specific technical change.
    Keywords: business cycles; expectations; news
    JEL: E3
    Date: 2006–10
  7. By: Hens, Thorsten (Institute for Empirical Research in Economics, University of Zurich); Mayer, Janós (Institute for Operations Research, University of Zurich); Pilgrim, Beate (Reuters AG, Frankfurt, Germany)
    Abstract: We consider economies with additively separable utility functions and give conditions for the two-agents case under which the existence of sunspot equilibria is equivalent to the occurrence of the transfer paradox. This equivalence enables us to show that sunspots cannot matter if the initial economy has a unique spot market equilibrium and there are only two commodities or if the economy has a unique equilibrium for all distributions of endowments induced by asset trade. For more than two agents the equivalence breaks and we give an example for sunspot equilibria even though the economy has a unique equilibrium for all distributions of endowments induced by asset trade.
    Keywords: Sunspot Equilibria; Intrinsically Complete Markets; Transfer Paradox
    JEL: C62
    Date: 2004–11–22
  8. By: Monika Piazzesi; Martin Schneider
    Abstract: This paper considers how the role of inflation as a leading business-cycle indicator affects the pricing of nominal bonds. We examine a representative agent asset pricing model with recursive utility preferences and exogenous consumption growth and inflation. We solve for yields under various assumptions on the evolution of investor beliefs. If inflation is bad news for consumption growth, the nominal yield curve slopes up. Moreover, the level of nominal interest rates and term spreads are high in times when inflation news are harder to interpret. This is relevant for periods such as the early 1980s, when the joint dynamics of inflation and growth was not well understood.
    JEL: E0 E3 E4 G0 G12
    Date: 2006–10
  9. By: Dirk Krueger; Hanno Lustig
    Abstract: In models with a large number of agents who have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks. In spite of the missing markets, a representative agent who consumes aggregate income prices the excess returns on stocks correctly. This result holds regardless of the persistence of idiosyncratic shocks, as long as they are not permanent, even when households face binding, and potentially very tight borrowing constraints. Consequently, in this class of models there is no link between the extent of self-insurance against idiosyncratic income risk and aggregate risk premia.
    JEL: E21 E44 G0
    Date: 2006–10
  10. By: Bovenberg,Lans; Uhlig,Harald (Tilburg University, Center for Economic Research)
    Abstract: This paper explores the optimal risk sharing arrangement between generations in an overlapping generations model with endogenous growth. We allow for nonseparable preferences, paying particular attention to the risk aversion of the old as well as overall "life-cycle" risk aversion. We provide a fairly tractable model, which can serve as a starting point to explore these issues in models with a larger number of periods of life, and show how it can be solved. We provide a general risk sharing condition, and discuss its implications. We explore the properties of the model quantitatively. Among the key findings are the following. First and for reasonable parameters, the old typically bear a larger burden of the risk in productivity surprises, if old-age risk-aversion is smaller than life risk aversion, and vice versa. Thus, it is not necessarily the case that the young ensure smooth consumption of the old. Second, consumption of the young and the old always move in the same direction, even for population growth shocks. This result is in contrast to the result of a fully-funded decentralized system without risk-sharing between generations. Third, persistent increases in longevity will lead to lower total consumption of the old (and thus certainly lower per-period consumption of the old) as well as the young as well as higher work effort of the young. The additional resources are instead used to increase growth and future output, resulting in higher consumption of future generations.
    Keywords: social optimum;pensions systems;risk sharing;overlapping
    JEL: E21 E61 E62 O40 H21 H55
    Date: 2006
  11. By: John D. Burger (Department of Economics, Loyola College in Maryland); Stephen J.K. Walters (Department of Economics, Loyola College in Maryland)
    Abstract: In a 1980 article in this journal, Cassing and Douglas provided widely-cited field evidence for the existence of a Winner’s Curse in the baseball labor market. This study takes advantage of recent developments in the measurement and valuation of individual output in this market to, first, reassess their finding of considerable overbidding for baseball free agents during the late 1970s. We find no evidence of negative average returns to teams on player contracts in these early years of free agency, though we do find evidence that teams had difficulty efficiently adjusting their bids in accord with available information, especially about risk. Next, we examine winning bids in a more recent and larger sample of players to test whether such systematic errors have persisted over time. The evidence indicates that teams continue to overvalue inconsistent (risky) free agents and are unable to limit their bids to conform to players’ lower values in small markets, though on average returns to winning bidders are non-negative. This is consistent with experimental evidence that finds bounded-rational behavior when bidders are faced with complex valuation problems involving multiple elements.
    Keywords: market efficiency, bounded rationality, overbidding
    JEL: D44 D81 J41 C93
    Date: 2006–10
  12. By: John D. Burger (Department of Economics, Loyola College in Maryland); Richard D. Grayson; Stephen J.K. Walters (Department of Economics, Loyola College in Maryland)
    Abstract: As a field study of choice under uncertainty, we examine baseball teams' investments in amateur players. Though most prospects fail to deliver any return on their multi-million dollar signing bonuses, returns on the minority who succeed easily offset these losses: the expected annual yield on the median first-round draftee is 33 percent. However, the pattern of returns is inconsistent with market efficiency. Yields are lower for high schoolers than collegians (27 percent vs. 43 percent), lower for pitchers than position players (24 percent vs. 41 percent), decline for later round long-shots, and may be negative under competitive bidding.
    Keywords: Market efficiency; Bounded rationality; Prospect theory; Winner’s curse
    JEL: D8 G14
    Date: 2006–10

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