nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2008‒05‒31
five papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Bidimensional Inequalities with an Ordinal Variable By N. GRAVEL; Patrick MOYES (GREThA UMR CNRS 5113)
  2. Measuring the Output and Prices of the Lottery Sector: An Application of Implicit Expected Utility Theory By Kam Yu
  3. No-arbitrage, overlapping sets of priors and the existence of efficient allocations and equilibria in the presence of risk and ambiguity By Rose-Anne Dana; Cuong Le Van
  4. Cognitive dissonance, risk aversion and the pretrial negotiation impasse By Langlais, Eric
  5. Investment Model Uncertainty and Fair Pricing By Los, Cornelis A.; Tungsong, Satjaporn

  1. By: N. GRAVEL; Patrick MOYES (GREThA UMR CNRS 5113)
    Abstract: We investigate the normative foundations of two empirically implementable dominance criteria for comparing distributions of two attributes, where the first one is cardinal while the second is ordinal. The criteria we consider are Atkinson and Bourguignon\'s (1982) first quasi-ordering and a generalization of Bourguignon\'s (1989) ordered poverty gap criterion. In each case we specify the restrictions to be placed on the individual utility functions, which guarantee that all utility-inequality averse welfarist ethical observers will rank the distributions under comparison in the same way as the dominance criterion. We also identify the elementary inequality reducing transformations successive applications of which permit to derive the dominating distribution from the dominated one.
    Keywords: Normative Analysis, Utilitarianism, Welfarism, Bidimensional Stochastic Dominance, Inequality Reducing Transformations
    JEL: D30 D63 I32
    Date: 2008
  2. By: Kam Yu
    Abstract: Using implicit expected utility theory, a money metric of utility derived from playing a lottery game is developed. Output of the lottery sector can be defined as the difference in utility with and without the game. Using a kinked parametric functional form, outputs of the Canadian Lotto 6/49 are estimated. Results show that this direct economic approach yield an average output which is almost three times of the official GDP, which takes total factor costs as output. A by-product of the estimation is an implicit price index for lottery, which can serve as a cost-of-living index for the CPI. The estimated price elasticity of demand -0.67 closely resembles results for the U.K. and Israel in previous studies.
    JEL: C43 D81 L83
    Date: 2008–05
  3. By: Rose-Anne Dana (CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - CNRS : UMR7534 - Université Paris Dauphine - Paris IX); Cuong Le Van (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I, Ecole d'économie de Paris - Paris School of Economics - Université Panthéon-Sorbonne - Paris I)
    Abstract: The theory of existence of equilibrium with short-selling is reconsidered under risk and ambiguity modelled by risk averse variational preferences. A sufficient condition for existence of efficient allocations is that the relative interiors of the risk adjusted sets of expectations overlap. This condition is necessary if agents are not risk neutral at extreme levels of wealths either positive or negative. It is equivalent to the condition that there does not exist mutually compatible trades, with non negative expected value with respect to any risk adjusted prior, strictly positive for some agent and some prior. It is shown that the more uncertainty averse and the more risk averse, the more likely are efficient allocations and equilibria to exist.
    Keywords: Uncertainty, risk, common prior, equilibria with short-selling, variational preferences.
    Date: 2008–05
  4. By: Langlais, Eric
    Abstract: There exist evidence that asymmetrical information do exist between litigants: not in a way supporting Bebchuk (1984)'s assumption that defendants' degree of fault is a private information, but more likely, as a result of parties' predictive power of the outcome at trial (Osborne, 1999). In this paper, we suggest an explanation which allows to reconcilie different results obtained in experimental economics. We assume that litigants assess their estimates on the plaintiff's prevailing rate at trial using a two-stage process. First, they manipulate the available information in a way consistent with the self-serving bias. Then, these priors are weighted according to the individual's attitude towards risk. The existence of these two different cognitive biases are well documented in the experimental literature. Within this framework, we study their influence in a model of litigation where the self-serving bias of one party is private information. We show that the influence of the former is consistent with the predictions of the "optimistic approach" of trials. However, we show that the existence of risk aversion and more generally non neutrality to risk, is more dramatic in the sense that it has more unpredictable effects.
    Keywords: litigation; pretrial bargaining; cognitive dissonance and self-serving bias; risk aversion.
    JEL: D81 K41
    Date: 2008–03
  5. By: Los, Cornelis A.; Tungsong, Satjaporn
    Abstract: Modern investment theory takes it for granted that a Security Market Line (SML) is as certain as its "corresponding" Capital Market Line. (CML). However, it can be easily demonstrated that this is not the case. Knightian non-probabilistic, information gap uncertainty exists in the security markets, as the bivariate "Galton's Error" and its concomitant information gap proves (Journal of Banking & Finance, 23, 1999, 1793-1829). In fact, an SML graph needs (at least) two parallel horizontal beta axes, implying that a particular mean security return corresponds with a limited Knightian uncertainty range of betas, although it does correspond with only one market portfolio risk volatility. This implies that a security' risk premium is uncertain and that a Knightian uncertainty range of SMLs and of fair pricing exists. This paper both updates the empirical evidence and graphically traces the financial market consequences of this model uncertainty for modern investment theory. First, any investment knowledge about the securities risk remains uncertain. Investment valuations carry with them epistemological ("modeling") risk in addition to the Markowitz-Sharpe market risk. Second, since idiosyncratic, or firm-specific, risk is limited-uncertain, the real option value of a firm is also limited-uncertain This explains the simultaneous coexistence of different analyst valuations of investment projects, particular firms or industries, included a category "undecided." Third, we can now distinguish between "buy", "sell" and "hold" trading orders based on an empirically determined collection of SMLs, based this Knightian modeling risk. The coexistence of such simultaneous value signals for the same security is necessary for the existence of a market for that security! Without epistemological investment uncertainty, no ongoing markets for securities could exist. In the absence of transaction costs and other inefficiencies, Knightian uncertainty is the necessary energy for market trading, since it creates potential or perceived arbitrage (= trading) opportunities, but it is also necessary for investors to hold securities. Knightian uncertainty provides a possible reason why the SEC can't obtain consensus on what constitutes "fair pricing." The paper also shows that Malkiel's recommended CML-based investments are extremely conservative and non-robust.
    Keywords: capital market line; security market line; beta; investments; decision-making; Knightian uncertainty; robustness; information-gap; Galton's Error; real option value
    JEL: G12 G11 C20 G13
    Date: 2008–05–24

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