nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2007‒06‒30
eleven papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Rationalizing Constrained Contingent Claims By Borglin, Anders; Flåm, Sjur
  2. Choquet OK? By John D Hey; Gianna Lotito; Anna Maffioletti
  3. Risk Aversion and Reservation Wages By Markus Pannenberg
  4. Risk, Government and Globalization: International Survey Evidence By Mayda, Anna Maria; O'Rourke, Kevin H; Sinnott, Richard
  5. Ambiguity and Social Interaction By Jürgen Eichberger; David Kelsey; Burkhard C. Schipper
  6. A Thermodynamic Theory of Economics By John Bryant
  7. Assessing the Relation between Equity Risk Premium and Macroeconomic Volatilities in the UK By Renatas Kizys; Peter Spencer
  8. Maximizing minimal rights for sustainability: a viability approach By Vincent Martinet
  9. The Fundamental Theory of Knowledge By Khumalo, Bhekuzulu
  10. Inefficient Policies and Incumbency Advantage By Roland Hodler; Simon Loertscher; Dominic Rohner
  11. Liquidity and Ambiguity: Banks or Asset Markets? By Jürgen Eichberger; Willy Spanjers

  1. By: Borglin, Anders (Department of Economics, Lund University); Flåm, Sjur (Economics Department, Bergen University)
    Abstract: Choice of contingent claims could reflect risk aversion or pessimism. Accordingly, the underlying, but hidden preferences might fit expected utility of customary von Neumann-Morgenstern form - or more generally, comply with a Choquet integral. This paper considers constrained choice and rationalizes both sorts of attitudes. Two avenues are pursued: one invokes complete orders; the other contends with partial ordering. Emphasis is on incomplete financial markets, featuring nonlinear pricing.
    Keywords: Nonlinear price; Risk or uncertainty aversion; Choquet integral; Stochastic order; Incomplete preferences
    JEL: C81 D01 G13
    Date: 2007–06–25
  2. By: John D Hey; Gianna Lotito; Anna Maffioletti
    Abstract: There is a large theoretical literature in both economics and psychology on decision making under ambiguity (as distinct from risk) and many preference functionals proposed in this literature for describing behaviour in such contexts. However, the empirical literature is scarce and largely confined to testing between various proposed functionals. Using a new design, in which we create genuine ambiguity in the laboratory and can control the amount of ambiguity, we generate data which enables us to estimate several of the proposed preference functionals. In particular, we fit Subjective Expected Utility, Prospect Theory, Choquet Expected Utility, Maximin, Maximax, and Minimum Regret preference functionals, and examine how the fit changes when we vary the ambiguity. We find that the Choquet formulation performs best overall, though it is clear that different decision makers have different functionals. We also identify new decision rules which are not explicitly modelled in the literature.
    Keywords: Ambiguity, Subjective Expected Utility, Prospect Theory, Choquet Expected Utility, Decision Making, Maximin, Maximax, Minimum Regret, Bingo Blower
    JEL: D81
    Date: 2007–06
  3. By: Markus Pannenberg (DIW Berlin, University of Applied Sciences Bielefeld and IZA)
    Abstract: This study examines the relationship between individual risk aversion and reservation wages using a novel set of direct measures of individual risk attitudes from the German Socio- Economic Panel (SOEP). We find that risk aversion has a significantly negative impact on the level of reservation wages. Moreover, we show that the elasticity of the reservation wage with respect to unemployment benefits is remarkably lower for risk-averse job seekers than for risk-loving job seekers. The results are consistent with an interpretation that risk-averse job seekers set their reservation wage levels sufficiently low, so that they accept almost every job offer.
    Keywords: risk aversion, reservation wages, survey data
    JEL: J64 J65
    Date: 2007–05
  4. By: Mayda, Anna Maria; O'Rourke, Kevin H; Sinnott, Richard
    Abstract: This paper uses international survey data to document two stylized facts. First, risk aversion is associated with anti-trade attitudes. Second, this effect is smaller in countries with greater levels of government expenditure. The paper thus provides evidence for the microeconomic underpinnings of the argument associated with Ruggie (1982), Rodrik (1998) and others that government spending can bolster support for globalization by reducing the risk associated with it in the minds of voters.
    Keywords: risk; trade attitudes
    JEL: F13 P16
    Date: 2007–06
  5. By: Jürgen Eichberger (University of Heidelberg, Department of Economics); David Kelsey (University of Exeter, Department of Economics); Burkhard C. Schipper (University of California, Davis, Department of Economics)
    Abstract: We present a non-technical account of ambiguity in strategic games and show how it may be applied to economics and social sciences. Optimistic and pessimistic responses to ambiguity are formally modelled. We show that pessimism has the effect of increasing (decreasing) equilibrium prices under Cournot (Bertrand) competition. In addition the effects of ambiguity on peace-making are examined. It is shown that ambiguity may select equilibria in coordination games with multiple equilibria. Some comparative statics results are derived for the impact of ambiguity in games with strategic complements.
    Keywords: Ambiguity, Optimism, Pessimism, Strategic Games, Oligopoly, Strategic Delegation, Peace-making, Strategic Complements, Choquet Expected Utility
    JEL: C72 D43 D62 D81
    Date: 2007–05
  6. By: John Bryant (Vocat International)
    Abstract: An analogy between thermodynamic and economic theories and processes is developed further, following a previous paper published by the author in 1982. Economic equivalents are set out concerning the ideal gas equation, the gas constant, pressure, temperature, entropy, work done, specific heat and the 1st and 2nd Laws of Thermodynamics. The law of diminishing marginal utility was derived from thermodynamic first principles. Conditions are set out concerning the relationship of economic processes to entropic gain. A link between the Le Chatelier principle and economic processes is developed, culminating in a derivation of an equation similar in format to that of Cobb Douglas production function, but with an equilibrium constant and a disequilibrium function added to it. A trade cycle is constructed, utilising thermodynamic processes, and equations are derived for cycle efficiency, growth and entropy gain. A thermodynamic model of a money system is set out, and an attempt is made to relate interest rates, the rate of return, money demand and the velocity of circulation to entropy gain. Aspects concerning the measurement of economic value in thermodynamic terms are discussed.
    Keywords: Thermodynamics, economics, Le Chatelier, entropy, utility, money, equilibrium, value, energy
    JEL: A1 C02 C68 D5 E O1
    Date: 2007–04
  7. By: Renatas Kizys; Peter Spencer
    Abstract: This paper uses the exponential generalised heteroscedasticity model-in-mean (EGARCH- M) to analyse the relationship between the equity risk premium and macroeconomic volatility. This premium depends upon conditional volatility, which is significantly affected by the long bond yield, acting as a proxy for the underlying rate of inflation.
    Keywords: Asset pricing, Risk premium, Macroeconomic volatility, Stochastic discount factor model, Multivariate EGARCH-M model
    JEL: C32 E32 E44 G12
    Date: 2007–06
  8. By: Vincent Martinet
    Abstract: This paper examines how the viability approach can be used to define sustainability goals. In an economic model with a non renewable natural resource, we define minimal rights to be guaranteed for all generations. These rights can include a minimal consumption (economic goal) and the preservation of natural resources (environmental goal). From a given economic state, it is possible to define the set of minimal rights that can be provided for all generation. To address the intergenerational equity issue, we propose to use a criterion that define the set of minimal rights that provide the maximal utility, in a Rawlsian perspective (Rawls, 1971). We describe how this criterion can be applied and computed, and discuss it with respect to usual criteria, including the maximin criterion, the Green Golden Rule, the Chichilnisky approach and the Mixed Bentham-Rawls criterion.
    Keywords: sustainability, intergenerational equity, minimal rights, viability
    JEL: Q01 Q32 O13 C61
    Date: 2007
  9. By: Khumalo, Bhekuzulu
    Abstract: This paper summarizes the theory of knowledge from the book of the same title by the same author. The paper begins by asking, and answering, what knowledge is. In searching for precise definitions it rids itself of the ambiguous term of infinity. The seven main laws of knowledge are laid out and discussed. The theory is an economic theory and as such must mention how people choose to seek knowledge. Knowledge is treated like any other commodity or product such as an apple, copper or a television set. Choices must be made in order to acquire knowledge. The tool used is the same tool used for analyzing other commodities - marginal utility analysis. The paper moves on to develop a working function of knowledge. This function helps to give a clear picture of how knowledge gains and loses occur within a society. The function leads to an understanding of critical levels of knowledge as well as the term obsolete knowledge. The paper introduces the term ‘negative’ knowledge and demonstrates how time is lost and gained within the context of knowledge. The sum of knowledge is the last major issue discussed in this paper and it can be considered the ‘signature’ of the theory. The concept that two plus two is not always four differentiates the commodity knowledge from other commodities and products. Finally the implications of this unique property of the commodity knowledge are discussed with the aim of demonstrating how the world would end up as a better place for all with food, shelter, and security for all.
    Keywords: Knowledge; time; mthetho; konke; critical level; negative knowledge; sum of knowledge
    JEL: O1 A10 D83
    Date: 2006–12–01
  10. By: Roland Hodler; Simon Loertscher; Dominic Rohner
    Abstract: We study incumbency advantage in a dynamic game with incomplete information between an incumbent and a voter. The incumbent knows the true state of the world, e.g., the severity of an economic recession or the level of criminal activities, and can choose the quality of his policy. This quality and the state of the world determine the policy outcome, i.e., the economic growth rate or the number of crimes committed. The voter only observes the policy outcome and then decides whether to reelect the incumbent or not. Her preferences are such that she would reelect the incumbent under full information if and only if the state of the world is above a given threshold level. In equilibrium, the incumbent is reelected in more states of the world than he would be under full information. In particular, he chooses ine±cient policies and generates mediocre policy outcomes whenever the voter's induced belief distribution will be such that her expected utility of reelecting the incumbent exceeds her expected utility of electing the opposition candidate. Hence, there is an incumbency advantage through ine±cient policies. We provide empirical evidence consistent with the prediction that reelection concerns may induce incumbents to generate mediocre outcomes.
    Keywords: Elections; Incumbency Advantage; Political Economics
    JEL: D72 C73
    Date: 2007
  11. By: Jürgen Eichberger (University of Heidelberg, Department of Economics); Willy Spanjers (Kingston University, School of Economics)
    Abstract: We study the impact of ambiguity on two alternative institutions of financial intermediation in an economy where consumers face uncertain liquidity needs. The ambiguity the consumers experience is modeled by the degree of confidence in their additive beliefs. We analyze the optimal liquidity allocation and two institutional settings for implementing this allocation: a secondary asset market and a bank deposit contract. For full confidence we obtain the well-known result that consumers prefer the bank deposit contract over the asset market, since the former can provide the optimal cross subsidy for consumers with high liquidity needs. With increasing ambiguity this preference will be reversed: the asset market is preferred, since it avoids inefficient liquidation if the bank reserve holdings turn out to be suboptimal.
    Keywords: Financial institutions, Liquidity, Ambiguity, Choquet Expected Utility.
    JEL: D8 G1 G2
    Date: 2007–06

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