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on Utility Models and Prospect Theory |
| By: | Jianying Qiu (Department of Economics, University of Innsbruck); Eva-Maria Steiger (Stratigic Interaction Group, Max Planck Institute of Economics, Jena, Germany) |
| Abstract: | In the framework of expected utility theory, risk attitudes are entirely captured by the curvature of the utility function. In cumulative prospect theory (CPT) risk attitudes have an additional dimension: the weighting of probabilities. With this modification, one question arises naturally: since both utility and probability weighting determine the attitude towards risk, what is the relation between them? We ran a controlled laboratory experiment to answer this question. Our ï¬ndings suggest that the two dimensions capture different characteristics of individual risk attitude. Though individuals who are risk averse in one dimension are likely to be risk averse in the other, the two dimensions show no signiï¬cant correlation. Moreover, a signiï¬cant proportion of subjects are risk averse in one dimension but risk seeking in the other. |
| Keywords: | Risk attitudes, Cumulative prospect theory, Experimental study |
| JEL: | C91 D81 |
| Date: | 2009–01–30 |
| URL: | http://d.repec.org/n?u=RePEc:jrp:jrpwrp:2009-006&r=upt |
| By: | Lence, Sergio H. |
| Abstract: | A thought experiment is designed to investigate whether the structure of risk aversion (i.e., the changes in absolute or relative risk aversion associated with changes in wealth) can be estimated with reasonable precision from agricultural production data. Findings strongly suggest that typical production data are unlikely to allow identification of the structure of risk aversion. A flexible utility parameterization is found to slightly worsen technology parameter estimates. Results also indicate that even under a restricted utility specification, utility parameter estimates are biased. Further, their quality is much worse when shocks are not large or samples are small. |
| Keywords: | expected utility, joint estimation, production analysis, risk attitudes, risk preferences |
| JEL: | C1 D2 D8 Q1 |
| Date: | 2009–02–03 |
| URL: | http://d.repec.org/n?u=RePEc:isu:genres:13028&r=upt |
| By: | Suen , Richard M. H. |
| Abstract: | The constant-relative-risk-aversion (CRRA) utility function is now predominantly used in quantitative macroeconomic studies. This function, however, is not bounded and thus creates problems when applying the standard tools of dynamic programming. This paper devises a method for "bounding" the CRRA utility functions. The proposed method is based on a set of conditions that can establish boundedness among a broad class of utility functions. These results are then used to construct a bounded utility function that is identical to a CRRA utility function except when consumption is very small or very large. It is shown that the constructed utility function also satisfies the Inada condition and is consistent with balanced growth. |
| Keywords: | Utility Function; Elasticity of Marginal Utility; Boundedness |
| JEL: | O41 C61 |
| Date: | 2009–02–07 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:13260&r=upt |
| By: | Tatjana Chudjakow (Institute of Mathematical Economics, Bielefeld University); Frank Riedel (Institute of Mathematical Economics, Bielefeld University) |
| Abstract: | We model and solve Best Choice Problems in the multiple prior framework: An ambiguity averse decision maker aims to choose the best among a fixed number of applicants that appear sequentially in a random order. The decision faces ambiguity about the probability that a candidate a relatively top applicant is actually best among all applicants. We show that our model covers the classical secretary problem, but also other interesting classes of problems. We provide a closed form solution of the problem for time-consistent priors using minimax backward induction. As in the classical case the derived stopping strategy is simple. Ambiguity can lead to substantial differences to the classical threshold rule. |
| Keywords: | Best Choice Problem |
| Date: | 2009–02 |
| URL: | http://d.repec.org/n?u=RePEc:bie:wpaper:413&r=upt |
| By: | Simone Cerreia-Vioglio; Fabio Maccheroni; Massimo Marinacci; Luigi Montrucchio |
| Abstract: | When there is uncertainty about interest rates (typically due to either illiquidity or defaultability of zero coupon bonds) the cash- additivity assumption on risk measures becomes problematic. When this assumption is weakened, to cash-subadditivity for example, the equivalence between convexity and the diversication principle no longer holds. In fact, this principle only implies (and it is implied by) quasiconvexity. For this reason, in this paper quasiconvex risk measures are studied. We provide a dual characterization of quasiconvex cash-subadditive risk measures and we establish necessary and sufficient conditions for their law invariance. As a byproduct, we obtain an alternative characterization of the actuarial mean value premium principle. |
| Keywords: | Risk Measures, Diversification, Cash-subadditivity, Quasiconvexity, Law-invariance, Mean Value Premium Principle |
| JEL: | D81 |
| Date: | 2008 |
| URL: | http://d.repec.org/n?u=RePEc:cca:wpaper:100&r=upt |
| By: | Theodoros M. Diasakos |
| Abstract: | I develop a model of endogenous bounded rationality due to search costs, arising implicitly from the decision problem's complexity. The decision maker is not required to know the entire structure of the problem when making choices. She can think ahead, through costly search, to reveal more of its details. However, the costs of search are not assumed exogenously; they are inferred from revealed preferences through choices. Thus, bounded rationality and its extent emerge endogenously: as problems become simpler or as the benefits of deeper search become larger relative to its costs, the choices more closely resemble those of a rational agent. For a fixed decision problem, the costs of search will vary across agents. For a given decision maker, they will vary across problems. The model explains, therefore, why the disparity, between observed choices and those prescribed under rationality, varies across agents and problems. It also suggests, under reasonable assumptions, an identifying prediction: a relation between the benefits of deeper search and the depth of the search. In decision problems with structure that allows the optimal foresight of search to be revealed from choices of plans of action, the relation can be tested on any agent-problem pair, rendering the model falsifiable. Moreover, the relation can be estimated allowing the model to make predictions with respect to how, in a given problem, changes in the terminal payoffs affect the depth of search and, consequently, choices. My approach provides a common framework for depicting the underlying limitations that force departures from rationality in different and unrelated decision-making situations. I show that it is consistent with violations of timing-independence in temporal framing problems, dynamic inconsistency and diversification bias in sequential versus simultaneous choice problems, and with plausible but contrasting risk attitudes across small- and large-stakes gambles. |
| Keywords: | bounded rationality, complexity, search |
| JEL: | D80 D83 |
| Date: | 2008 |
| URL: | http://d.repec.org/n?u=RePEc:cca:wpaper:90&r=upt |
| By: | Nævdal , Eric (Ragnar Frisch Centre for Economic Research); Vislie, Jon (Dept. of Economics, University of Oslo) |
| Abstract: | Discounting in the presence of catastrophic risk is a hotly debated issue, in particular with respect to climate change. Many scientists and laymen concerned with potentially catastrophic impacts feel that if an increase in the discount rate drastically increases the likelihood of catastrophic outcomes, this discredits economic cost-benefit calculations. This paper argues that this intuition is sound and that if cost-benefit calculations are done within a model that encompasses the type of catastrophic risk that these scientists worry about, the resulting stabilization target will only be slightly influenced by the discount rate. This is shown within a stylized model of a risk neutral decision maker facing a problem with a catastrophic threshold with unknown location. |
| Keywords: | climate change; discounting; catastrophic risk; optimal control |
| JEL: | A10 |
| Date: | 2008–11–01 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:osloec:2008_028&r=upt |
| By: | James Feigenbaum (University of Pittsburgh); Frank N. Caliendo (Department of Economics and Finance, Utah State University); Emin Gahramanov (Deakin University) |
| Abstract: | Contrary to the usual presumption that welfare is maximized if consumers behave rationally, we show in a two-period overlapping generations model that there always exists a rule of thumb that can weakly improve upon the lifecycle/permanent-income rule in general equilibrium with irrational households. The market-clearing mechanism introduces a pecuniary externality that individual rational households do not consider when making decisions, but a publically shared rule of thumb can exploit this effect. For typical calibrations, the improvement of the welfare of irrational households is robust to the introduction of rational agents. Generalizing to a more realistic lifecycle model, we find in particular that the Save More Tomorrow(TM) (SMarT) Plan can confer higher lifetime utility than the permanent-income rule in general equilibrium. |
| Keywords: | consumption, saving, coordination, lifecycle/permanent-income hypothesis, SMarT Plan, general equilibrium, rules of thumb, pecuniary externality |
| JEL: | C61 D11 E21 |
| Date: | 2009–02–03 |
| URL: | http://d.repec.org/n?u=RePEc:uth:wpaper:200901&r=upt |