
on Utility Models and Prospect Theory 
By:  Richard Layard; Guy Mayraz; Stephen Nickell 
Abstract:  In both public economics and welfare analysis it is crucial to know how fast the marginal utility ofincome declines as income increases. One needs this parameter for costbenefit analysis, for optimaltaxation and for the (Atkinson) measurement of inequality. We estimate this parameter using fourcrosssectional surveys of subjective wellbeing and two panel surveys. Altogether, we use data fromover 50 countries, and in a period extending from 1972 to 2005. In all six surveys we find aremarkably consistent relationship between reported wellbeing and income. We estimate theelasticity of marginal utility with respect to income at around (minus) 1.25. Thus, marginal utilitydeclines somewhat faster than in the case (assumed by Dalton and others) when wellbeing is linear inlog income. In the second part of the paper, however, we ask whether true wellbeing may not have aconvex relationship to reported wellbeing, making it less concave with respect to income. We findsome evidence of this, so that the correct elasticity of marginal utility with respect to income isroughly (minus) 1.15. These figures show that Dalton's theoretical assumption was not far from thetruth revealed by empirical evidence, and provide scientific estimates which can be used in allbranches of economics applied to public policy. 
Keywords:  Marginal utility, income, life satisfaction, happiness, public economic, welfare, inequality,optimal taxation, referencedependent preferences 
JEL:  I31 H00 D1 D61 H21 
Date:  2007–03 
URL:  http://d.repec.org/n?u=RePEc:cep:cepdps:dp0784&r=upt 
By:  JeanDaniel Guigou; Bruno Lovat; Gwenaël Piase 
Abstract:  We study the relations between compensation schemes and risk aversion of managers in a strategic framework. We first show that the use of relative performance evaluation (RPE) in compensation contracts reduces the equilibrium profits of Cournot firms if managers are not too risk averse. Second, we introduce entry issues in our model. We then show that forbidding RPE can favour competition. 
Keywords:  Executive Compensation, Relative Performance Evaluation, Moral Hazard, Market Structure. 
JEL:  D43 D82 D86 
Date:  2007 
URL:  http://d.repec.org/n?u=RePEc:ulp:sbbeta:200726&r=upt 
By:  Olivier Blanchard; Jordi Gali 
Abstract:  We develop a utility based model of fluctuations, with nominal rigidities, and unemployment. In doing so, we combine two strands of research: the New Key nesian model with its focus on nominal rigidities, and the DiamondMortensenPissarides model, with its focus on labor market frictions and unemployment. In developing this model, we proceed in two steps. We first leave nominal rigidities aside. We show that, under a standard utility specification, productivity shocks have no effect on unemployment in the constrained effcient allocation. We then focus on the implications of alternative real wage setting mechanisms for fluctuations in unemployment. We then introduce nominal rigidities in the form of staggered price setting by firms. We derive the relation between inflation and unemployment and discuss how it is influenced by the presence of real wage rigidities. We show the nature of the tradeoff between inflation and unemployment stabilization, and we draw the implications for optimal monetary policy. 
Keywords:  new Keynesian model, labor market frictions, search model, unemployment, sticky prices, real wage rigidities 
JEL:  E32 E50 
Date:  2007–06 
URL:  http://d.repec.org/n?u=RePEc:kie:kieliw:1335&r=upt 
By:  Mark Huggett; Gustavo Ventura; Amir Yaron 
Abstract:  Is lifetime inequality mainly due to differences across people established early in life or to differences in luck experienced over the working lifetime? We answer this question within a model that features idiosyncratic shocks to human capital, estimated directly from data, as well as heterogeneity in ability to learn, initial human capital, and initial wealth  features which are chosen to match observed properties of earnings dynamics by cohorts. We find that as of age 20, differences in initial conditions account for more of the variation in lifetime utility, lifetime earnings and lifetime wealth than do differences in shocks received over the lifetime. Among initial conditions, variation in initial human capital is substantially more important than variation in learning ability or initial wealth for determining how an agent fares in life. An increase in an agent's human capital affects expected lifetime utility by raising an agent's expected earnings profile, whereas an increase in learning ability affects expected utility by producing a steeper expected earnings profile. 
JEL:  D31 D91 E21 
Date:  2007–07 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:13224&r=upt 
By:  Paul Levine (Department of Economics, University of Surrey, Guildford, Surrey, GU2 7XH, United Kingdom.); Joseph Pearlman (London Metropolitan University, 31 Jewry Street, London, EC3N 2EY, United Kingdom.); Richard Pierse (Department of Economics, University of Surrey, Guildford, Surrey, GU2 7XH, United Kingdom.) 
Abstract:  We examine the linearquadratic (LQ) approximation of nonlinear stochastic dynamic optimization problems in macroeconomics, in particular for monetary policy. We make four main contributions: first, we draw attention to a general Hamiltonian framework for LQ approximation due toMagill (1977). We show that the procedure for the ‘large distortions’ case of Benigno and Woodford (2003, 2005) is equivalent to the Hamiltonian approach, but the latter is far easier to implement. Second, we apply the Hamiltonian approach to a Dynamic Stochastic General Equilibrium model with external habit in consumption. Third, we introduce the concept of targetimplementability which fits in with the general notion of targeting rules proposed by Svensson (2003, 2005). We derive sufficient conditions for the LQ approximation to have this property in the vicinity of a zeroinflation steady state. Finally, we extend the Hamiltonian approach to a noncooperative equilibrium in a twocountry model. JEL Classification: E52, E37, E58. 
Keywords:  Linearquadratic approximation, dynamic stochastic general equilibrium models, utilitybased loss function. 
Date:  2007–06 
URL:  http://d.repec.org/n?u=RePEc:ecb:ecbwps:20070759&r=upt 
By:  Alex Cukierman; Alberto Dalmazzo 
Abstract:  OBJECTIVES AND MOTIVATION: This paper considers the impact of interactions between competitiveness, fiscal policy and monetary institutions in the presence of unionized labor markets on economic outcomes and welfare in the long run. Two main classes of questions are investigated. First, what is the impact of exogenously given labor taxes and unemployment benefits on the choice of monetary policy by the central bank, on the choice of nominal wages by unions, on the choice of prices by monopolistically competitive firms and through them on unemployment, inflation and welfare? A related question is, how does the level of competitiveness on goods’ market affect the economy and welfare? Second, how are labor taxes and redistribution chosen by a (Stackelberg leader) fiscal authority whose objectives are a weighted average of social welfare and of catering to the interests of political supporters, and how does the general equilibrium induced by this choice affect welfare? The framework of the paper is motivated by the European scene in which the fraction of the labor force covered by collective agreements dominates wage setting in the labor market. “PLAYERS” AND PAYOFFS: The model economy features labor unions that maximize the expected real income of union members over states of employment and of unemployment, a central bank that strives to minimize the combined costs of inflation and of unemployment, and a continuum of monopolistically competitive firms, each of which maximizes its profits. The last part of the paper also features a fiscal authority that sets taxes and redistribution so as to maximize a combination of social welfare and of benefits to particular constituencies. Utility from consumption is characterized by means of a CES, DixitStiglitz, utility function and (as in Sidrauski type models) money appears in the utility function. METHODOLOGY AND “PLAYERS” STRATEGIES: The first question is investigated within a three stage game in which labor unions move first and commit to nominal wages and the central bank moves second and chooses the money supply. In the third and last stage each of a large number of monopolistically competitive firms picks its price. To deal with the second class of questions the game is expanded to feature a preliminary stage in which government chooses labor taxes and redistribution anticipating the subsequent responses of the other players. General equilibrium is characterized and used to find the impact of various economic and institutional parameters. 
Date:  2007–06 
URL:  http://d.repec.org/n?u=RePEc:kie:kieliw:1338&r=upt 
By:  Miguel Ángel Hinojosa (Department of Economics, Quantitative Methods and Economic History, Universidad Pablo de Olavide); Amparo Mª Mármol (Department of Applied Economics III, Universidad de Sevilla); José Manuel Zarzuelo (Department of Applied Economics IV, Universidad del País Vasco) 
Abstract:  This paper introduces and analyzes the class of multiutilitarian solutions for cooperative bargaining problems. We show that generalized Gini solutions and inequality averse Choquet bargaining solutions are particular cases of this new multivalued solution concept and provide a complete characterization of inequality averse multiutilitarian solutions in which an invariance property consisting of a weakening of both the linear invariance axiom in Blackorby et al. (1994) and the restricted invariance axiom in Ok and Zhou (2000). Moreover, by relaxing the assumptions involved in the characterization, the class is extended to include equality averse multiutilitarian solutions which are also studied in the paper. 
Keywords:  Axiomatic bargaining theory, multivalued bargaining solutions, generalized Gini solutions, inequality adverse Choquet solutions. 
JEL:  C61 C78 
Date:  2007–07 
URL:  http://d.repec.org/n?u=RePEc:pab:wpaper:07.13&r=upt 