nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2008‒03‒01
thirteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. How Investors Face Financial Risk Loss Aversion and Wealth Allocation By Erick Rengifo; Emanuela Trifan
  2. Risk Aversion and Trade Union Membership By Laszlo Goerke; Markus Pannenberg
  3. Experience Weighted Attraction in the First Price Auction and Becker Degroot Marschak By Duncan James; Derrick Reagle
  4. On the Curvature of the Reporting Function from Objective Reality to Subjective Feelings By Oswald, Andrew J
  5. The Effects of Foreign Price Uncertainty on Australian Production and Trade By Elie Appelbaum; Alan D. Woodland
  6. A Behavioural Approach To Financial Puzzles By Marie-Hélène Broihanne; Maxime Merli; Patrick Roger
  7. Non-Market Wealth, Background Risk and Portfolio Choice By Günter Franke; Harris Schlesinger; Richard Stapleton
  8. A note on the nature of utility in time and health and implications for cost utility analysis By Ken Buckingham; Nancy Devlin
  9. The Equity Premium: A Deeper Puzzle By Francisco Azeredo
  10. Asset return and wealth dynamics with reference dependent preferences and heterogeneous beliefs By Sergiy Gerasymchuk
  11. Social choice and information: a note on the calculus of mappings from utility spaces By Alex Coram
  12. A Test of the Rational Expectations Hypothesis using data from a Natural Experiment By Anna Conte; Peter G. Moffatt; Fabrizio Botti; Daniela Di Cagno; Carlo D'Ippoliti
  13. Rational Reasoning or Adaptive Behavior? Evidence from Two-Person Beauty Contest Games By Brit Grosskopf; Rosemarie Nagel

  1. By: Erick Rengifo (Fordham University, Department of Economics); Emanuela Trifan (J.W. Goethe University Frankfurt am Main, Department of Economics)
    Abstract: We study how the wealth-allocation decisions and the loss aversion of non-professional investors change subject to behavioral factors. The optimal wealth assignment between risky and risk-free assets results within a VaR portfolio model, where risk is individually assessed according to an extended prospect-theory framework. We show how the past performance and the portfolio evaluation frequency impact investor behavior. Myopic loss aversion holds at different evaluation frequencies. One year is the optimal frequency at which, under practical constraints, risky holdings are maximized. Previous research using standard VaR-significance levels may underestimate the loss aversion of individual investors.
    Keywords: Prospect theory, myopic loss aversion, Value-at-Risk, portfolio evaluation, capital allocation
    JEL: G10 G11 D81 E27
    Date: 2008
  2. By: Laszlo Goerke; Markus Pannenberg
    Abstract: In an open-shop model of trade union membership with heterogeneity in risk attitudes, a worker's relative risk aversion can affect the decision to join a trade union. Furthermore, a shift in risk attitudes can alter collective bargaining outcomes. Using German panel data (GSOEP) and three novel direct measures of individual risk aversion, we find evidence of a significantly positive relationship between risk aversion and the likelihood of union membership. Additionally, we observe a negative correlation between bargained wages in aggregate and average risk preferences of union members. Our results suggest that an overall increase in risk aversion contributes to wage moderation and promotes employment.
    Keywords: Employment, membership, risk aversion, trade union
    JEL: J
    Date: 2008
  3. By: Duncan James (Fordham University, Department of Economics); Derrick Reagle (Fordham University, Department of Economics)
    Abstract: In this paper we explore the performance of Experience Weighted Attraction (EWA) in two different auction institutions: First Price Sealed Bid, and Becker-DeGroot-Marschak. Our results suggest that learning has some promise as a possible explanation for previously documented cross- institutional choice anomalies usually attributed to risk aversion. Additionally, we present results on the likely econometric (ir)recoverability of EWA parameters in these institutions.
    Keywords: Auctions, Risk Aversion, Learning, Experience Weighted Attractions
    Date: 2008
  4. By: Oswald, Andrew J (University of Warwick)
    Abstract: I suggest the idea of a reporting function, r(.), from reality to feelings. The ‘happiness’ literature claims we have demonstrated diminishing marginal utility of income. I show not, and that knowing r(.)’s curvature is crucial. A quasi-experiment on heights is studied.
    Keywords: Money ; diminishing marginal utility ; height ; concavity
    JEL: I3 D1
    Date: 2008
  5. By: Elie Appelbaum (York University, Canada); Alan D. Woodland (Faculty of Economics and Business, University of Sydney)
    Abstract: This paper provides a framework for the empirical analysis of the role of uncertain international prices for the Australian economy’s production sector and its international trade. We model the movement of traded goods prices via a bivariate GARCH model and embed this within an expected utility maximizing model of the production sector. We find that the empirical results are consistent with expected utility maximization and that the hypothesis of risk neutrality is soundly rejected. Estimates of the effects of changes in expected prices and volatility of traded goods prices upon production decisions and the return to capital are presented and discussed, as are the impacts of changes in output growth of Australia’s major trading partners. The overall conclusion is that price uncertainty matters for the Australian production sector.
    Keywords: Price uncertainty, production under risk, expected utility maximization, international trade
    JEL: F10 C51
    Date: 2008–01
  6. By: Marie-Hélène Broihanne; Maxime Merli; Patrick Roger (Laboratoire de Recherche en Gestion et Economie, Université Louis Pasteur)
    Abstract: Many financial puzzles have been solved, at least partially, by the introduction of alternative assumptions on the behaviour of investors. Cumulative prospect theory and mental accounting are two such approaches which are used in this paper to analyze some of the most important financial puzzles. We first focus our attention on anomalies (or considered as such in the standard expected utility model) at the individual level, for example the disposition effect or the low diversification puzzle. We then address two aggregate puzzles, namely the equity premium puzzle and the return predictability puzzle. We show how recent behavioral models allow to explain these anomalies in a very natural way.
    Date: 2008
  7. By: Günter Franke (University of Konstanz); Harris Schlesinger; Richard Stapleton
    Abstract: We examine the effects of non-portfolio risks on optimal portfolio choice. Examples of non-portfolio risks include, among others, uncertain labor income, uncertainty about the terminal value of fixed assets such as housing and uncertainty about future tax liabilities . In particular, while some of these risks are added to portfolio value and have been amply studied, others are multiplicative in nature and have received far less attention. Moreover, the combined effects of multiple risks lead to some seemingly paradoxical choice behavior. We rationalize such behavior and we show how non-portfolio risks might lead to seemingly U-shaped relative risk aversion for a representative investor, as found empirically by Ait-Sahilia and Lo (2000) and Jackwerth (2000).
    Keywords: Portfolio choice, Derived relative risk aversion, Additive background risk, Multiplicative background risk
    JEL: G11
    Date: 2007–07–26
  8. By: Ken Buckingham (Department of Preventive and Social Medicine, University of Otago, New Zealand); Nancy Devlin (Department of Economics, City University, London)
    Abstract: Time Trade-Off valuations of health are widely used in economic evaluation of health care. Current approaches to eliciting TTO values, and their use in economic evaluation, rests on specific assumptions about the way utility relates to time and health. Both the assumptions themselves and evidence of violations of them are discussed in the literature - yet the issues appear not to be widely appreciated by those using and applying TTO. This paper adds to that literature by demonstrating both the requirements of TTO and violations of these assumptions in terms of the underlying indifference curve maps and utility functions. The advantage of this approach is that is demonstrates very clearly a number of fundamental problems for the way TTO values are currently elicited and used in Cost Utility Analysis. In essence, it is extremely unwise to assume that the current ‘tariffs’ of TTO values, such as those routinely used by NICE and other organisations, can be applied irrespective of the duration of the health states to which they are assigned. The estimates of QALYs that result will, quite often, simply be wrong. We suggest a number of solutions, including the provision of multiple value sets, for a range of durations.
    Keywords: TTO; utility, QALYs, maximal endurable time
    Date: 2008–02
  9. By: Francisco Azeredo (University of California - Santa Barbara)
    Abstract: Traditional pre-1930 consumption measures understate the extent of serial correlation in the U.S. annual real growth rate of per capita consumption of non-durables and services due to measurement limitations in the construction of their major components. Under alternative measures proposed in this study, the serial correlation of consumption growth is found to be 0.32, contrary to the original estimate of -0.14. This new evidence implies that the class of dynamic general equilibrium models studied by Mehra and Prescott [12] generates negative equity premium for reasonable risk-aversion levels, thus further exacerbating the equity premium puzzle.
    Keywords: persistence, consumption growth, equity premium puzzle, neoclassical growth model,
    Date: 2007–09–01
  10. By: Sergiy Gerasymchuk (Department of Applied Mathematics, University of Venice)
    Abstract: We study a model of a financial market populated with heterogenous agents whose preferences exhibit dependence on some reference level of wealth. Investment decisions of the agents are myopic and are based upon the demand for the risky asset derived from an S-shaped utility maximization. The specific demand form allows to model both heterogeneity of the system relative to the reference points of the agents and heterogeneity with respect to their beliefs about the future asset return. We analyze the impact of the former layer of heterogeneity on the asset return and wealth dynamics.
    JEL: C62 C63 D84 G12
    Date: 2008–01
  11. By: Alex Coram (Robert Gordon University, Scotland, and The University of Western Australia)
    Abstract: Social choice is studied in this paper as a mapping from information on utilities over states of the world to an ordering of those states of the world. The idea of using this type of information originates in the work of Sen and Roberts. This paper differs in that it uses theorems from analysis to derive its results in a straightforward manner. It also gives information on the way in which all states of the world, on any path through the set of states of the world, must be ordered. JEL Categories: D60, D71.
    Keywords: social choice theory, information, analysis.
    Date: 2008–02
  12. By: Anna Conte (Department of Economic and Business Sciences, LUISS Guido Carli); Peter G. Moffatt (School of Economics, University of East Anglia); Fabrizio Botti (Department of Economic and Business Sciences, LUISS Guido Carli); Daniela Di Cagno (Department of Economic and Business Sciences, LUISS Guido Carli); Carlo D'Ippoliti (Department of Economic and Business Sciences, LUISS Guido Carli)
    Abstract: Data on contestantsÕ choices in Italian Game Show Affari Tuoi are analysed in a way that separates the effect of risk attitude from that of beliefs concerning the amount of money that will be offered to contestants in future rounds. The importance of belief-formation is confirmed by the estimation of a mixture model which establishes that the vast majority of contestants are forward-looking as opposed to myopic. The most important issue addressed in the paper is what belief function is actually being used by contestants. This function is estimated in an unconstrained way as a component of the choice model, which is estimated using maximum simulated likelihood. Separate identification of the belief function and preferences is possible by virtue of the fact that at a certain stage of the game, beliefs are not relevant, and risk attitude is the sole determinant of choice. The rational expectations hypothesis is tested by comparing the estimated belief function with the ÒtrueÓ offer function which is estimated using data on offers actually made to contestants. We find that there is a significant difference between these two functions, and hence we reject the rational expectations hypothesis. However, when a simpler Òrule-of-thumbÓ structure is assumed for the belief function, we find a correspondence to the function obtained from data on actual offers. Our overall conclusion is that contestants are rational to the extent that they make use of all available relevant information, but are not fully rational because they are not processing the information in an optimal way. The importance of allowing the choice data to convey the belief function without prejudice is emphasised.
    Keywords: beliefs, discrete choice models, simulated likelihood, natural experiments, rational expectations, risky choices
    JEL: C15 C23 C25 D81
    Date: 2007–08
  13. By: Brit Grosskopf; Rosemarie Nagel
    Abstract: Many experiments have shown that human subjects do not necessarily behave in line with game theoretic assumptions and solution concepts. The reasons for this non-conformity are multiple. In this paper we study the argument whether a deviation from game theory is because subjects are rational, but doubt that others are rational as well, compared to the argument that subjects, in general, are boundedly rational themselves. To distinguish these two hypotheses, we study behavior in repeated 2-person and many-person Beauty- Contest-Games which are strategically different from one another. We analyze four different treatments and observe that convergence toward equilibrium is driven by learning through the information about the other player’s choice and adaptation rather than self-initiated rational reasoning.
    Keywords: Beauty contest, Guessing game, Bounded rationality, Weak dominance, Learning
    JEL: C7 C9
    Date: 2007–06

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