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on Utility Models and Prospect Theories |
| By: | Ali al-Nowaihi; Ian Bradley; Sanjit Dhami |
| Abstract: | Prospect theory is the main behavioral alternative to expected utility. Tversky and Kahnemann (1992) motivate the utility function for gains and losses under prospect theory by using the axiom of preference homogeneity. However, they do not provide the formal proof. We provide the relevant proof. Furthermore, we show that the utility function under preference homogeneity obeys an additional and important restriction that is not noted by Tversky and Kahnemann (1992). This simplifies the use of prospect theory by reducing the number of free parameters by one. |
| Keywords: | Prospect Theory; Preference homogeneity; Functional equations |
| JEL: | C60 D81 |
| Date: | 2006–11 |
| URL: | http://d.repec.org/n?u=RePEc:lec:leecon:06/15&r=upt |
| By: | Fernandez, Pablo (IESE Business School) |
| Abstract: | This paper is a review of the recommendations about the equity premium found in the main finance and valuation textbooks. We review several editions of books written by authors such as Brealey and Myers; Copeland, Koller and Murrin (McKinsey); Ross, Westerfield and Jaffe; Bodie, Kane and Marcus; Damodaran; Copeland and Weston; Van Horne; Bodie and Merton; Stowe et al.; Pratt; Penman; Bruner; Weston & Brigham; and Arzac. We highlight the confusing message the textbooks convey regarding the equity premium and how it changes. The main confusion arises from not distinguishing among the four concepts that the term "equity premium" designates: Historical equity premium (HEP), Expected equity premium, Required equity premium (REP) and Implied equity premium (IEP). Some confusion also arises from not recognizing that although the HEP is equal for all investors, the REP, the EEP and the IEP are different for different investors. A unique IEP requires assuming homogeneous expectations for expected growth (g), but there are several pairs (IEP, g) that satisfy current prices. We claim that different investors have different REPs and that it is impossible to determine the REP for the market as a whole, because it does not exist. |
| Keywords: | equity premium; equity premium puzzle; required market risk premium; historical market risk premium; expected market risk premium; risk premium; market risk premium; market premium; |
| JEL: | G12 G31 M21 |
| Date: | 2006–10–24 |
| URL: | http://d.repec.org/n?u=RePEc:ebg:iesewp:d-0657&r=upt |
| By: | Sanjit Dhami; Ali al-Nowaihi |
| Abstract: | A celebrated result in the economics of crime, which we call the Becker proposition (BP), states that it is optimal to impose the severest possible punishment (to maintain effective deterrence) at the lowest possible probability (to economize on enforcement costs). Several other applications, some unrelated to the economics of crime, arise when an economic agent faces punishments/ rewards with very low probabilities. For instance, insurance against low probability events, principal-agent contracts that impose punitive fines, seat belt usage and the usage of mobile phones among drivers etc. However, the BP, and the other applications mentioned above, are at variance with the evidence. The BP has largely been considered within an expected utility framework (EU). We re-examine the BP under rank dependent expected utility (RDU) and prospect theory (PT). We find that the BP always holds under RDU. However, under plausible scenarios within PT it does not hold, in line with the evidence. |
| Keywords: | Behavioral economics; Illegal activity; Expected utility theory; Rank dependent expected utility; Prospect theory; Prelec and higher order Prelec probability weighting functions |
| JEL: | D81 K42 |
| Date: | 2006–11 |
| URL: | http://d.repec.org/n?u=RePEc:lec:leecon:06/14&r=upt |
| By: | Donald J. Brown (Economic Growth Center, Yale University); Rahul Deb (Yale University); Marten H. Wegkamp (Florida State University) |
| Abstract: | A common stochastic restriction in econometric models separable in the latent variables is the assumption of stochastic independence between the unobserved and observed exogenous variables. Both simple and composite tests of this assumption are derived from properties of independence empirical processes and the consistency of these tests is established. As an application, we stimulate estimation of a random quasilinear utility function, where we apply our tests of independence. |
| Keywords: | Cramér-von Mises distance, empirical independence processes, random utility models, semiparametric econometric models, specification test of independence |
| JEL: | C12 C13 C30 C52 |
| Date: | 2006–10 |
| URL: | http://d.repec.org/n?u=RePEc:egc:wpaper:946&r=upt |
| By: | Henryk, Gzyl; Silvia, Mayoral |
| Abstract: | We study the relationship between two widely used risk measures, the spectral measures and the distortion risk measures. In both cases, the risk measure can be thought of as a re-weighting of some initial distribution. We prove that spectral risk measures are equivalent to distorted risk pricing measures, or equivalently, spectral risk functions are related to distortion functions. Besides that we prove that distorted measures are absolutely continuous with respect to the original measure. |
| Keywords: | Coherent risk measure; distortion function; Spectral measures; Risk Aversion Function. |
| JEL: | G11 |
| Date: | 2006–11 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:916&r=upt |
| By: | Bjarne S. Jensen; Paul de Boer |
| Abstract: | In this paper, we unify and extend the analytical and empirical application of the ”indirect addilog” expenditure system, introduced by Leser (1941), Somermeyer- Wit (1956) and Houthakker (1960). Using the Box-Cox transform, we present a parametric analysis of the Houthakker specification of the fundamental indirect utility function - called the CDES specification (constant differences of Allen elasticities of substitution) by Hanoch (1975). It is shown that the CDES demand system is less restrictive than implied by standard parameter restrictions in the literature, Hanoch (1975), Deaton & Muellbauer (1980), or else neither adequately indicated, Houthakker (1960), Silberberg & Suen (2001). Our parametric examination implies that Marshallian own-price elasticities are no longer restricted to being all larger than one in absolute value; hence CDES can now naturally exhibit both the inelastic and elastic own price elasticities of observable (Marshallian) demands. Furthermore, we argue that in computable general equilibrium models (CGE), the CDES compares favorably with other expenditure systems, e.g. the linear expenditure system (LES), since CDES and LES need the same outside information for calibration of the parameters, but CDES is not confined to constancy of marginal budget shares (linear Engel curves). Moreover, we show that the non-homothetic CDES preferences are a simple and natural extension of the homothetic CES (constant elasticities of substitution) preferences, and, accordingly, CDES can more realistically be used in specifying CGE models with a demand side of non-unitary income elasticities. A succint theoretical briefing of the CDES history with general and concise formulas is offered. We illustrate CDES estimation and the calculation of a comprehensive set of income and price elasticities by applying CDES to Danish budget survey data. With a large number budget items included, coherent numerical values for the income, own, and cross price elasticities, as shown here, seem nowhere calculated and available in the voluminous literature. |
| Keywords: | CDES demand systems, non-homothetic preferences, general price elasticities, CGE modeling, budget data implementation |
| Date: | 2006–06 |
| URL: | http://d.repec.org/n?u=RePEc:deg:conpap:c011_056&r=upt |
| By: | Paul de Boer; Bjarne S. Jensen |
| Date: | 2005–06 |
| URL: | http://d.repec.org/n?u=RePEc:deg:conpap:c010_036&r=upt |
| By: | Atsushi Kajii (Institute of Economic Research, Kyoto University) |
| Abstract: | We study a standard two period exchange economy with one nominal asset. As is well known there is a continuum of sunspot equilibria around each efficient equilibrium. A sunspot equilibrium is inefficient but some household may gain in sunspot equilibria relative to the efficient equilibrium. We show that a householdfs equilibrium utility level is either locally maximized or locally minimized at the efficient equilibrium, and derive a condition which identifies whether or not a householdfs utility is locally minimized or maximized. |
| Date: | 2006–10 |
| URL: | http://d.repec.org/n?u=RePEc:kyo:wpaper:624&r=upt |
| By: | Natálie Reichlová (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic) |
| Abstract: | According to Abraham Maslow's motivational theory, human action is motivated by five groups of human needs. The model introduced in this paper exploits Maslow's theory to explain migration flows between regions. In the model, movement from one place to another influences migrant's utility through three various ways. First, through change in wage caused by different wage levels in each location. Second, through changes in utility connected with individuals safety needs and finally, through disarrangement of individual's social networks. When safety and social needs are added to the model, equilibria arise in which wage differential between regions persists. |
| Keywords: | agent-based modeling; decision making; migration; motivation; networks |
| JEL: | J61 F22 I31 O15 |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fau:wpaper:wp097&r=upt |
| By: | Paul A. de Hek |
| Abstract: | This paper studies the effects of taxation on long-run growth in a two-sector endogenous growth model with (i) physical capital as an input in the education sector and (ii) leisure as an additional argument in the utility function. Due to the flexibility of labor supply, taxation of income may induce agents to spend more or less time on leisure activities. Income taxation - the same rate applies for capital and labor income - reduces the growth rate. The contribution of endogenous leisure in this case is confined to reducing or increasing the size of the effect on the growth rate. The same is true if only labor income is taxed. However, if only capital income is taxed, the sign of the effect may reverse. In that case, the positive effect of the increase in total non-leisure time dominates the direct negative effect, implying that capital taxation increases the long-run growth rate. |
| Date: | 2005–06 |
| URL: | http://d.repec.org/n?u=RePEc:deg:conpap:c010_010&r=upt |