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on Utility Models and Prospect Theory |
| By: | Ingrid Groessl (Department for Economics and Politics, University of Hamburg); Ulrich Fritsche (Department for Economics and Politics, University of Hamburg, and DIW Berlin) |
| Abstract: | Assuming a risk-neutral bank and assuming household utility to be exponential, we show how under information symmetry the covariance of income and loan repayments may explain higher household borrowings than in the case without default option. Under ex post information asymmetry and positive control costs, the result is less clear-cut. We also make evident that in a situation in which a household without default option would neither borrow nor save, the existence of a default option makes household borrowing behaviour unpredictable. |
| Keywords: | Consumption, exponential utility, certainty equivalent, households, default option, borrowing, risk, risk aversion, risk management |
| JEL: | D11 D14 D18 D53 D81 |
| Date: | 2007–09 |
| URL: | http://d.repec.org/n?u=RePEc:hep:macppr:200705&r=upt |
| By: | Ali al-Nowaihi; Sanjit Dhami |
| Abstract: | In a major contribution, Loewenstein and Prelec (1992) (LP) set the foundations for the behavioral approach to decision making over time. We show that the LP theory is incompatible with two very useful classes of value functions: the HARA class and the constant loss aversion class. Resultingly, the LP theory has been used infrequently in applications, which have largely used the ß, ? form of hyperbolic preferences. We propose a more general but equally tractable class of utility functions, the simple increasing elasticity (SIE) class, which is compatible with constant loss aversion in a reformulated version of LP. Allowing for reference dependence and different discount rates for gains and losses the SIE class is able to explain impatience, gain-loss asymmetry, magnitude effect, and the delay-speedup asymmetry even under exponential discounting. If combined instead with the (reformulated) LP theory, the SIE class in addition can also explain the common difference effect. |
| Keywords: | Anomalies of the DU model; Intertemporal choice; Generalized hyperbolic discounting; loss aversion; HARA utility functions; SIE value functions |
| JEL: | C60 D91 |
| Date: | 2007–09 |
| URL: | http://d.repec.org/n?u=RePEc:lec:leecon:07/9&r=upt |
| By: | Schied, Alexander; Schöneborn, Torsten |
| Abstract: | We consider the finite-time optimal portfolio liquidation problem for a von Neumann-Morgenstern investor with constant absolute risk aversion (CARA). As underlying market impact model, we use the continuous-time liquidity model of Almgren and Chriss (2000). We show that the expected utility of sales revenues, taken over a large class of adapted strategies, is maximized by a deterministic strategy, which is explicitly given in terms of an analytic formula. The proof relies on the observation that the corresponding value function solves a degenerate Hamilton-Jacobi-Bellman equation with singular initial condition. |
| Keywords: | Liquidity; illiquid markets; optimal liquidation strategies; dynamic trading strategies; algorithmic trading; utility maximization |
| JEL: | G24 G20 G10 |
| Date: | 2007–09–27 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:5075&r=upt |
| By: | Sanjit Dhami; Ali al-Nowaihi |
| Abstract: | The predictions of expected utility theory (EUT) applied to tax evasion are flawed on two counts: (i) They are quantitatively in error by huge orders of magnitude. (ii) Higher taxation is predicted to lower evasion, which is at variance with the evidence. An emerging literature in behavioral economics, most notably based on prospect theory (PT), has shown that behavioral economics is much better at explaining tax evasion. We extend this literature to incorporate issues of optimal taxation. As a benchmark for a successful theory, we require that it should explain, jointly, the facts on the tax rate, tax gap and the level of government expenditure. We find that when taxpayers use EUT (respectively, PT) and the optimal tax is derived from a social welfare function that also uses EUT (respectively, PT), then, the calibration results are completely at odds with the facts. However, when taxpayers use PT but the social welfare function uses standard EUT, there is a very close match between the predictions and the facts. This has important implications for context dependent preferences but also for the newly emerging literature on liberalism versus paternalism in behavioral economics. |
| Keywords: | Prospect theory; Expected utility theory; Tax evasion; Optimal taxation; Normative versus positive economics; Context dependent preferences; Liberalism; Paternalism |
| JEL: | D81 H26 K42 |
| Date: | 2007–09 |
| URL: | http://d.repec.org/n?u=RePEc:lec:leecon:07/10&r=upt |
| By: | Matthew Rabin (University of California, Berkeley); Georg Weizsäcker (London School of Economics and IZA) |
| Abstract: | An experiment by Tversky and Kahneman (1981) illustrates that people's tendency to evaluate risky decisions separately can lead them to choose combinations of choices that are first-order stochastically dominated by other available combinations. We investigate the generality of this effect both theoretically and experimentally. We show that for any decisionmaker who does not have constant-absolute-risk-averse preferences and who evaluates her decisions one by one, there exists a simple pair of independent binary decisions where the decisionmaker will make a dominated combination of choices. We also characterize, as a function of a person's preferences, the amount of money that she can lose due to a single mistake of this kind. The theory is accompanied by both a real-stakes laboratory experiment and a large-sample survey from the general U.S. population. Replicating Tversky and Kahneman's original experiment where decisionmakers with prototypical prospect-theory preferences will choose a dominated combination, we find that 28% of the participants do so. In the survey we ask the respondents about several hypothetical large-stakes choices, and find higher proportions of dominated choice combinations. A statistical model that estimates preferences from the survey results is best fit by assuming people have utility functions that are close to prospect-theory value functions and that about 83% of people bracket narrowly. None of these results varies strongly with the personal characteristics of participants. We also demonstrate directly that dominated choices are driven by narrow bracketing: when we eliminate the possibility of narrow bracketing by using a combined presentation of the decisions, the dominated choices are eliminated in the laboratory experiment and are greatly reduced in the survey. |
| Keywords: | lottery choice, narrow framing, representative-sample experiments |
| JEL: | B49 |
| Date: | 2007–09 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp3040&r=upt |
| By: | Simon Clark |
| Abstract: | This paper examines a class of two-sided matching problems with non-transferable utility. Agents are horizontally differentiated, and each would prefer to be matched to a similar partner, i.e. "like attracts like". such preferences imply a unique equilibrium assignment describing the pattern of matching; however, the pattern of assortment in equilibrium is found to depend critically on the distribution of types among the two sexes. Classification-JEL: C7 |
| Keywords: | Matching, sorting, uniqueness, horizontal heterogeneity, marriage. |
| URL: | http://d.repec.org/n?u=RePEc:edn:esedps:171&r=upt |
| By: | Isacsson, Gunnar (VTI); Swärdh, Jan-Erik (VTI) |
| Abstract: | The purpose of this paper is to estimate the average value of commuting time (VoCT) in an empirical on-the-job search model. A large Swedish sample of employee-establishment linked data obtained from administrative registers is used to this end. The sample contains detailed information on the individuals' place of residence and place of work and it is combined with information on travel times and travel distances in the road network. We use two empirical models of the individuals' utility function: a basic model and an augmented model. The latter introduces a set of variables intended to capture the effect of interpersonal comparisons of earnings and commuting times in the individual's utility function and on the estimated VoCT. The basic model suggests the average VoCT to be as high as 232 Swedish kronor (SEK) per hour, which is about two and half times higher than the net hourly wage rate in the sample. If we discard the effect of interpersonal comparisons of earnings and commuting time on job switching, the augmented model instead suggests a value of time of 94 SEK, which is more or less equal to the net hourly wage rate in the sample. |
| Keywords: | Value of commuting time; Revealed preferences; Relative earnings |
| JEL: | C41 C81 J60 R41 |
| Date: | 2007–09–20 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:vtiwps:2007_012&r=upt |
| By: | Carla Sá (Universidade do Minho - NIPE); Raymond Florax (Purdue University and Vrije Universiteit Amsterdam); Piet Rietveld (Vrije Universiteit Amsterdam and Tinbergen Institute) |
| Abstract: | This paper analyses the nature of university and living-arrangement decisions at the example of Dutch students with a secondary education academic diploma. A random utility maximization nested logit model of living-arrangement and university decisions is estimated, allowing for distance and rent e¤ects to vary according to the decision on whether to stay at parental home. Estimation results show that distance deters both at-homers and out-homers. Dutch youngsters are guided by consumption motives, rather than investment motives. They appear to attend university where their high school mates do. Tight housing markets lower the probability of choosing a given university. Male and low income students stay longer with parents, as do those with non-Dutch parents. |
| Keywords: | living arrangements, university choice, random utility maximization, nested logit |
| JEL: | C25 D85 I2 J24 R00 |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:nip:nipewp:14/2007&r=upt |