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on Utility Models and Prospect Theory |
| By: | Nick Draper |
| Abstract: | This paper evaluates approximation methods to make manageable the numerical solution of overlapping generation models with aggregate risk. The paper starts with a model in which households maximize expected utility over their life cycle. Instantaneous utility is characterized by constant relative risk aversion. Prudence, a characteristic of the utility function, leads to precautionary saving. The first-order conditions include expectations. One source of uncertainty is not prohibitive for numerical integration of the expectation term. Because of its accuracy numerical integration results are used as a bench mark. Taylor series approximations can lead to the same results dependent on the linearization point. A linear quadratic approximation of the household model is evaluated subsequently. Alternatively, precautionary saving effects can be the result of robust decision making. This approach leads to linear policy functions and gives a rather good approximation of the bench mark model, although not as good as the Taylor series approximation. |
| Keywords: | Precautionary saving; Robustness; Prudence |
| JEL: | E21 D81 C61 |
| Date: | 2008–04 |
| URL: | http://d.repec.org/n?u=RePEc:cpb:memodm:196&r=upt |
| By: | Alessandro Bucciol; Raffaele Miniaci |
| Abstract: | We derive from a sample of US households the distribution of the risk aversion implicit in their portfolio choice. Our estimate minimizes the distance between the certainty equivalent return generated with observed portfolios and portfolios that are optimal in a mean-variance framework. Taking into account real wealth and constraints in portfolio composition, we obtain a median risk aversion coefficient of 2.7 and observe substantial heterogeneity across individuals. Our analysis informs that risk aversion reduces with wealth and education, and increases with age. Disregarding real wealth and constraints, our estimates are markedly larger and the direction of the above correlations differs. The inferred optimization bias is small, especially with over-simplified portfolios. |
| Date: | 2008 |
| URL: | http://d.repec.org/n?u=RePEc:ubs:wpaper:0808&r=upt |
| By: | Charles F. Manski |
| Abstract: | This paper concerns the prescriptive function of decision analysis. I suppose that an agent must choose an action yielding welfare that varies with the state of nature. The agent has a welfare function and beliefs, but he does not know the actual state of nature. It is often argued that such an agent should adhere to consistency axioms which imply that behavior can be represented as maximization of expected utility. However, our agent is not concerned the consistency of his behavior across hypothetical choice sets. He only wants to make a reasonable choice from the choice set that he actually faces. Hence, I reason that prescriptions for decision making should respect actuality. That is, they should promote welfare maximization in the choice problem the agent actually faces. I conclude that any decision rule respecting weak and stochastic dominance should be considered rational. Expected utility maximization respects dominance, but it has no special status from the actualist perspective. Moreover, the basic consistency axiom of transitivity has a clear normative foundation only when actions are ordered by dominance. |
| JEL: | D81 |
| Date: | 2008–10 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:14396&r=upt |
| By: | Anton Suvorov (CEFIR, NES); Jeroen van de Ven |
| Abstract: | We develop a theory of self-regulation based on goal setting for an agent with present-biased preferences. Preferences are assumed to be reference-dependent and exhibit loss aversion, as in prospect theory. The reference point is determined endogenously as an optimal self-sustaining goal. The interaction between hyperbolic discounting and loss aversion makes goals a credible and effective instrument for self-regulation. This is an entirely internal commitment device that does not rely on reputation building. We show that in some cases it is optimal to engage in indulgent behavior, and sometimes it is optimal to set seemingly dysfunctional goals. Finally, we derive a condition under which proximal (short term) goals are better than distal (long term) goals. Our results provide an implicit evolutionary rationale for the existence of loss aversion as a means of self-control. |
| Keywords: | self-regulation, goals, time inconsistency, loss aversion, indulgence, compulsiveness, proximal and distal |
| JEL: | D00 D80 D90 |
| Date: | 2008–10 |
| URL: | http://d.repec.org/n?u=RePEc:cfr:cefirw:w0122&r=upt |
| By: | Gary E Bolton; Axel Ockenfels |
| Date: | 2008–09–30 |
| URL: | http://d.repec.org/n?u=RePEc:kls:series:0040&r=upt |
| By: | Marie-Louise Leroux; Grégory Ponthière |
| Abstract: | This paper studies the normative problem of redistribution between agents who can infuence their survival probability through private health spending, but who differ in their attitude towards the risks involved in the lotteries of life to be chosen. For that purpose, a two-period model is developed, where agents' preferences on lotteries of life can be represented by a mean and variance utility function allowing, unlike the expected utility form, some sensitivity to what Allais (1953) calls the dispersion of psychological values. It is shown that if agents ignore the impact of their health spending on the return of their savings, the decentralization of the first-best utilitarian optimum requires intergroup lump-sum transfers and group-specifc taxes on health spending. Under asymmetric information, we find that subsidizing health expenditures may be optimal as a way to solve the incentive problem. |
| Date: | 2008 |
| URL: | http://d.repec.org/n?u=RePEc:pse:psecon:2008-46&r=upt |