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on Utility Models and Prospect Theory |
| By: | James C. Cox; Vjollca Sadiraj; Bodo Vogt; Utteeyo Dasgupta |
| Abstract: | A large literature is concerned with analysis and empirical application of theories of decision making for environments with risky outcomes. Expected value theory has been known for centuries to be subject to critique by St. Petersburg paradox arguments. More recently, theories of risk aversion have been critiqued with calibration arguments applied to concave payoff transformations. This paper extends the calibration critique to decision theories that represent risk aversion solely with transformation of probabilities. Testable calibration propositions are derived that apply to four representative decision theories: expected utility theory, cumulative prospect theory, rank-dependent expected utility theory, and dual expected utility theory. Heretofore, calibration critiques of theories of risk aversion have been based solely on thought experiments. This paper reports real experiments that provide data on the relevance of the calibration critiques to evaluating the plausibility of theories of risk aversion. The paper also discusses implications of the data for (original) prospect theory with editing of reference payoffs and for the new dual-self model of impulse control. In addition, the paper reports an experiment with a truncated St. Petersburg bet that adds to data inconsistent with risk neutrality. |
| Date: | 2007–06 |
| URL: | http://d.repec.org/n?u=RePEc:exc:wpaper:2007-05&r=upt |
| By: | Sarah Jacobson; Ragan Petrie |
| Abstract: | Lottery experiments have been performed in many contexts to test theories of risk aversion and to measure risk preferences. People are typically offered a series of lotteries with increasing expected payoffs and variances. A person with a concave utility function should switch from risky bets to safer bets at some point and never switch back. Switching back implies preferences inconsistent with a concave utility function. Our experiment, conducted with a population of adults in Rwanda, presents respondents with a series of binary-choice lotteries over gains and losses. We observe that 54-55% of subjects made at least one inconsistent choice over gains or losses, and 7-13% made at least two inconsistent choices. This holds for both hypothetical and real lottery payoffs. Inconsistent choices were less common when stakes were higher, and women are more likely to be inconsistent. While risk aversion alone is not correlated with actual economic outcomes, such as membership in savings (tontines) and insurance groups and holding a larger number of bank accounts, inconsistency is. |
| Date: | 2007–04 |
| URL: | http://d.repec.org/n?u=RePEc:exc:wpaper:2007-03&r=upt |
| By: | Jean-Philippe Chancelier (cermics, Ecole des ponts, Paris Tech); Michel De Lara (cermics, Ecole des ponts, Paris Tech); André de Palma (Université de Cergy-Pontoise, Ecole nationale des ponts et chaussées, core and Institut universitaire de France) |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:ema:worpap:2007-15&r=upt |
| By: | Björn Hagströmer; Richard G. Anderson; Jane M. Binner; Thomas Elger; Birger Nilsson |
| Abstract: | In a portfolio choice setting of three common assets (FTSE 100, FTSE 250 and FTSE Emerging Market Index), we identify several utility functions under which Full-Scale Optimization is a substantially better approach than the mean variance approach is. With the Full-Scale Optimization approach the complete empirical financial return probability distribution is considered, and the utility maximising solution is found through grid search. Earlier studies have shown that this approach is useful for investors following non-linear utility functions (such as bilinear and S-shaped utility) and choosing between highly non-normally distributed assets, such as hedge funds. We expand the area of usage to common indices, and show that the results are robust for a broader range of utility function specifications. |
| Keywords: | Great Britain |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2007-016&r=upt |
| By: | Charles M. Harvey (University of Houston); Lars Peter Østerdal (Department of Economics, University of Copenhagen) |
| Abstract: | Models of preferences between outcomes over continuous time are important for individual, corporate, and social decision making, e.g., medical treatment, infrastructure development, and environmental regulation. This paper presents a foundation for such models. It shows that conditions on preferences between real- or vector-valued outcomes over continuous time are satisfied if and only if the preferences are represented by a value function having an integral form. |
| Keywords: | continuous time; discounting; ordinal utility scale; value function; integral |
| JEL: | D11 H43 I18 |
| Date: | 2007–05 |
| URL: | http://d.repec.org/n?u=RePEc:kud:kuiedp:0710&r=upt |
| By: | Arthur Lewbel (Boston College) |
| Abstract: | Shape invariance is a property of demand functions that is convenient for semiparametric demand modelling. All known shape invariant demands are derived from utility functions that, up to monotonic transformation, are called IB/ESE (independent of base - equivalence scale exact) utility functions, because they yield IB/ESE equivalence scales, which are widely used in welfare calculations. This paper provides a counterexample, i.e., a shape invariant demand system that is not derived from a transform of IB/ESE utility. A general theorem is then provided that characterizes all shape invariant demand systems. The usual practice of equating shape invariance with the IB/ESE utility class is shown to be not quite right, but it can be made valid by testing for the small class of exceptions noted here. In particular, all the exceptions have rank two, so any rank three or higher shape invariant system must be derived from transforms of IB/ESE utility. |
| Keywords: | Shape Invariance, Equivalence Scales, Engel curves, Consumer demand, Demand Systems, Utility, Cost Functions. |
| JEL: | D11 D12 C31 C51 |
| Date: | 2007–06–13 |
| URL: | http://d.repec.org/n?u=RePEc:boc:bocoec:669&r=upt |
| By: | Jean Imbs; Paolo Mauro |
| Abstract: | In this paper, we identify the groups of countries where international risk-sharing opportunities are most attractive. We show that the bulk of risk-sharing gains can be achieved in groups consisting of as few as seven members, and that further marginal benefits quickly become negligible. For many such small groups, the welfare gains associated with risk sharing can amount to one order of magnitude larger than Lucas's classic calibration suggested for the United States, under similar assumptions on utility. Why do we not observe more arrangements of this type? Large welfare gains can only be achieved within groups where contracts are probably seen as relatively difficult to enforce. International diversification can thus yield substantial gains, but these may remain untapped owing to potential partners' weak institutional quality and a history of default on international obligations. Noting that existing risk sharing arrangements often have a regional dimension, we speculate that shared economic interests such as common trade may help sustain such arrangements, though risk-sharing gains are smaller when membership is constrained on a regional basis. |
| Date: | 2007–06–08 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:07/132&r=upt |
| By: | Daniel L.Thornton |
| Abstract: | There are two unresolved puzzles in the empirical foreign exchange literature. The first is the finding that tests of forward rate unbiasedness using the forward rate and forward premium equations yield markedly different conclusions. A companion puzzle - the forward premium puzzle - is the fact that the forward premium incorrectly predicts the direction of the subsequent change in the spot rate, which implies a massive rejection of uncovered interest parity. This paper resolves both puzzles. |
| Keywords: | Foreign exchange |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2007-014&r=upt |
| By: | Sokbae Lee; Myunghwan Seo |
| Abstract: | This paper is concerned with semiparametric estimation of a threshold binaryresponse model. The estimation method considered in the paper is semiparametricsince the parameters for a regression function are finite-dimensional, whileallowing for heteroskedasticity of unknown form. In particular, the paper considersManski (1975, 1985)'s maximum score estimator. The model in this paper isirregular because of a change-point due to an unknown threshold in a covariate.This irregularity coupled with the discontinuity of the objective function of themaximum score estimator complicates the analysis of the asymptotic behavior ofthe estimator. Sufficient conditions for the identification of parameters are givenand the consistency of the estimator is obtained. It is shown that the estimator ofthe threshold parameter is n-consistent and the estimator of the remainingregression parameters is cube root n-consistent. Furthermore, we obtain theasymptotic distribution of the estimators. It turns out that a suitably normalizedestimator of the regression parameters converges weakly to the distribution towhich it would converge weakly if the true threshold value were known andlikewise for the threshold estimator. |
| Keywords: | Binary response model, maximum score estimation, semiparametricestimation, threshold regression, nonlinear random utility models. |
| JEL: | C25 |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:cep:stiecm:/2007/516&r=upt |
| By: | Pelikan, Pavel |
| Abstract: | "Rationality" is understood in the empirical sense of cognitive abilities of human brains for solving economic problems, and consequently recognized bounded in individually unequal ways. This is shown to require treating it as a unique scarce resource, used for deciding on its own uses. This uniqueness disturbs axiomatic economics by a tangled hierarchy, and implies that rationality-allocation can approach efficiency only by means of an institutionally shaped trial-and-error evolution. Applied to the markets vs. government issue, a comparative institutional analysis of rationality-allocation yields novel insights with non-standard policy implications, and thus demonstrates that rationality-allocation matters. |
| Keywords: | unequally bounded rationality; rationality-allocation; tangled hierarchy; institutionally shaped evolution; comparative institutional analysis |
| JEL: | P5 D6 H1 D72 |
| Date: | 2007–05 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:3657&r=upt |