nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2007‒12‒15
eleven papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Risky Choice and Type-Uncertainty in "Deal or No Deal?" By Gee, C.
  2. Non-classical expected utility theory with application to type indeterminacy By Vladimir I. Danilov; Ariane Lambert-Mogiliansky
  3. Comparison of Mean-Variance Theory and Expected-Utility Theory through a Laboratory Experiment By Andrea Morone
  4. Testing Guilt Aversion By Ellingsen, Tore; Johannesson, Magnus; Tjøtta, Sigve; Torsvik, Gaute
  5. Reexamination on Updating Choquet Beliefs By Mayumi Horie
  6. Tests of Independence in Separable Econometric Models: Theory and Application By Donald J. Brown; Rahul Deb; Marten H. Wegkamp
  7. Optimal Correction for Guessing in Multiple-Choice Tests. By María Paz Espinosa; Javier Gardeazabal
  9. A General Update Rule for Convex Capacities By Mayumi Horie
  10. Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints By Tsvetanka Karagyozova
  11. Institutions for Intuitive Man By Christoph Engel

  1. By: Gee, C.
    Abstract: This paper uses data from the popular television game-show, "Deal or No Deal?", to analyse the way individuals make choices under risk. In a unique approach to the problem, I present a formal game-theoretical model of the show in which both the contestant and the banker are modelled as strategic players. I use standard techniques to form hypotheses of how rational expected utility-maximisers would behave as players in the game and I test these hypotheses with the relevant choice data. The main result is that an increasing o¤er function is the result of optimal behaviour when the banker is uncertain about the contestant.s risk attitudes. This result provides a theoretical foundation to the empirical model of the banker that pervades the literature. Estimates of the coefficient of relative risk aversion are consistent with estimates from other studies and estimates of the discernment parameter suggest contestants have difficulty making choices.
    Keywords: Choice under Risk, Expected Utility, Asymmetric Information, Risk-Aversion
    JEL: C72 C93 D81 D82
    Date: 2007–11
  2. By: Vladimir I. Danilov; Ariane Lambert-Mogiliansky
    Abstract: In this paper we extend Savage's theory of decision-making under uncertainty from a classical environment into a non-classical one. We formulate the corresponding axioms and provide representation theorems for qualitative measures and expected utility. We also propose an application in simple game context in the spirit of Harsanyi.
    Date: 2007
  3. By: Andrea Morone (University of Bari.)
    Abstract: In the 40.s and early 50. two decision theories were proposed and have since dominated the scene of the fascinating field of decision-making. In 1944 . when von Neumann and Morgenstern showed that if preferences are consistent with a set of axioms then it is possible to represent these preferences by the expectation of some utility function . Expected Utility theory provides a natural way to establish .measurable utility.. In the early 50.s Markowitz introduced the Mean-Variance theory that is the basis of modern portfolio selection theory. Even if both models were analyzed from virtually all possible points of view; although they were tested against several generalizations; even though they seem to be the most attractive theories of decision making, they were never tested against each other. This paper will try to fill this gap. It investigates, using experimental data, which of these two models represent a better approximation of subjects. preferences.
    Keywords: Expected utility, Mean variance, preference functional, pair wise choice, experiments.
    JEL: C92 G12
    Date: 2007–10
  4. By: Ellingsen, Tore (Dept. of Economics, Stockholm School of Economics); Johannesson, Magnus (Dept. of Economics, Stockholm School of Economics); Tjøtta, Sigve (Department of Economics, University of Bergen); Torsvik, Gaute (Department of Economics, University of Bergen)
    Abstract: Guilt averse individuals experience a utility loss if they believe they let someone down. In particular, generosity depends on what the donor believes that the recipient expects to receive. In experimental work, several authors have identified a positive correlation between such second-order donor beliefs and generous behavior, as predicted by the guilt aversion hypothesis. However, the correlation could alternatively be due to a “false consensus effect,” i.e., the tendency of people to believe others to think like themselves. In order to test the guilt aversion hypothesis more rigorously, we conduct three separate experiments: a dictator game experiment, a complete information trust game experiment, and a hidden action trust game experiment. In the experiments we inform donors about the beliefs of their respective recipients, while eliciting these beliefs so as to maximize recipient honesty. The correlation between generous behavior and donors’ second-order beliefs is close to zero in all three experiments.
    Keywords: guilt aversion; beliefs; generosity; experiments
    JEL: C91 D64
    Date: 2007–12–07
  5. By: Mayumi Horie (Institute of Economic Research, Kyoto University)
    Abstract: Eichberger, Grant, and Kelsey (2007) characterize the full Bayesian update rule for capacities. This paper shows that a conditional preference relation represented by the Choquet expected utility with respect to the updated capacity through the rule does not satisfy the axiom of Conditional Certainty Equivalence Consistency. A counterexample is provided and it is proved that a relaxation of the axiom maintains their results.
    Keywords: Bayesian update, capacity, conditional preference, Choquet expected utility
    JEL: D81
    Date: 2007–11
  6. By: Donald J. Brown (Cowles Foundation, Yale University); Rahul Deb (Dept. of Economics, Yale University); Marten H. Wegkamp (Dept. of Statistics, 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 simulate estimation of a random quasilinear utility function, where we apply our tests of independence.
    Keywords: Cramer-von Mises distance, Empirical independence processes, Random utility models, Semiparametric econometric models, Specification test of independence
    JEL: C01 C13 C14 C15 D12
    Date: 2003–01
  7. By: María Paz Espinosa (The University of the Basque Country); Javier Gardeazabal (The University of the Basque Country)
    Abstract: Building on Item Response Theory we introduce students’ optimal behavior in multiple-choice tests. Our simulations indicate that the optimal penalty is relatively high, because although correction for guessing discriminates against risk-averse subjects, this effect is small compared with the measurement error that the penalty prevents. This result obtains when knowledge is binary or partial, under different normalizations of the score, when risk aversion is related to knowledge and when there is a pass-fail break point. We also find that the mean degree of difficulty should be close to the mean level of knowledge and that the variance of difficulty should be high.
    Keywords: Multiple choice test, Item Response Theory, formula scoring,
    JEL: A20 D81 I2
    Date: 2007–12–05
  8. By: Melisso Boschi; Aditya Goenka
    Abstract: We study how investor behaviour affects the transmission of ?financial crises. If investors exhibit decreasing relative risk aversion, then negative wealth shocks increase the risk premium required to hold risky assets. We integrate this into a second generation model of currency crises which allows for a competitiveness e¤ect and for contagion through changes in fundamentals. The investor behaviour can lead to the transmission of ?financial crises even in the absence of the competitiveness effect, and makes multiple equilibria more likely. The possible stabilization effects of capi- tal controls and a Tobin tax on the international transmission of ?financial crises are also studied.
    JEL: D91 F31 F32 G11 G15
    Date: 2007–10
  9. By: Mayumi Horie (Institute of Economic Research, Kyoto University)
    Abstract: A characterization of a general update rule for convex capacities, the G-updating rule, is investigated. We introduce a consistency property which bridges between unconditional and conditional preferences, and deduce an update rule for unconditional capacities. The axiomatic basis for the G-updating rule is established through consistent counterfactual acts, which take the form of trinary acts expressed in terms of G, an ordered tripartition of global states.
    Keywords: ambiguous belief, Bayes' rule, update rule, convex capacity, Choquet ex- pected utility, conditional preference
    JEL: D81
    Date: 2007–11
  10. By: Tsvetanka Karagyozova (University of Connecticut and University of British Columbia)
    Abstract: The consumption capital asset pricing model is the standard economic model used to capture stock market behavior. However, empirical tests have pointed out to its inability to account quantitatively for the high average rate of return and volatility of stocks over time for plausible parameter values. Recent research has suggested that the consumption of stockholders is more strongly correlated with the performance of the stock market than the consumption of non-stockholders. We model two types of agents, non-stockholders with standard preferences and stock holders with preferences that incorporate elements of the prospect theory developed by Kahneman and Tversky (1979). In addition to consumption, stockholders consider fluctuations in their financial wealth explicitly when making decisions. Data from the Panel Study of Income Dynamics are used to calibrate the labor income processes of the two types of agents. Each agent faces idiosyncratic shocks to his labor income as well as aggregate shocks to the per-share dividend but markets are incomplete and agents cannot hedge consumption risks completely. In addition, consumers face both borrowing and short-sale constraints. Our results show that in equilibrium, agents hold different portfolios. Our model is able to generate a time-varying risk premium of about 5.5% while maintaining a low risk free rate, thus suggesting a plausible explanation for the equity premium puzzle reported by Mehra and Prescott (1985).
    Keywords: asset pricing, equity premium puzzle, prospect theory, heterogeneous agents
    JEL: G12 E44
    Date: 2007–11
  11. By: Christoph Engel (Max Planck Institute for Research on Collective Goods, Bonn)
    Abstract: By its critics, the rational choice model is routinely accused of being unrealistic. One key objection has it that, for all nontrivial problems, calculating the best response is cognitively way too taxing, given the severe cognitive limitations of the human mind. If one confines the analysis to consciously controlled decision-making, this criticism is certainly warranted. But it ignores a second mental apparatus. Unlike conscious deliberation, this apparatus does not work serially but in parallel. It handles huge amounts of information in almost no time. It only is not consciously accessible. Only the end result is propelled back to consciousness as an intuition. It is too early to decide whether the rational choice model is ultimately even descriptively correct. But at any rate institutional analysts and institutional designers are well advised to take this powerful mechanisms seriously. In appropriate contexts, institutions should see to it that decision-makers trust their intuitions. This frequently creates a dilemma. For better performance is often not the only goal pursued by institutional intervention. Accountability, predictability and regulability are also desired. Sometimes, clever interventions are able to get them both. Arguably, the obligation to write an explicit set of reasons for a court decision is a case in point. The judge is not obliged to report the mental processes by which she has taken her decision. Justification is only ex post control. Intuitive decision-making is even more desirable if the underlying social problem is excessively complex (NP hard, to be specific), or ill-defined. Sometimes, it is enough for society to give room for intuitive decision-making. For instance, in simple social dilemmas, a combination of cheater detection and punishing sentiments does the trick. However, intuition can be misled. For instance, punishing sentiments are triggered by a hurt sense of fairness. Now in more complex social dilemmas, there are competing fairness norms, and people intuitively choose with a self-serving bias. In such contexts, institutions must step in so that clashing intuitions do not lead to social unrest.
    Keywords: intuition, consciousness, rational choice, heuristics, ill-defined social problems, institutions
    JEL: B52 C72 D01 D02 D81 K40 K42
    Date: 2007–08

This nep-upt issue is ©2007 by Alexander Harin. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.