nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2009‒12‒19
eighteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Ruptures in the probability scale? Calculation of ruptures’ dimensions By Harin, Alexander
  2. Theory of the firm under multiple uncertainties By Moawia, Alghalith
  3. Preferences estimation without approximation By Moawia, Alghalith
  4. Are People Really Risk Seeking for Losses? By Kontek, Krzysztof
  5. Social preferences under risk: an experimental analysis By Bradler, Christiane
  6. Constructive Decision Theory By Blume, Lawrence; Easley, David; Halpern, Joseph Y.
  7. The Illusion of Irrationality By Kontek, Krzysztof
  8. Fundamental uncertainty, portfolio choice, and liquidity preference theory By Pasche, Markus
  9. Fairness: A Critique to the Utilitarian Approach By Philipp Kircher; Sandra Ludwig; Alvaro Sandroni
  10. A reason-based theory of rational choice By Dietrich Franz; List Christian
  11. Utility from Accumulation By Louis Kaplow
  12. Risk-Adjusted Gamma Discounting By Martin L. Weitzman
  13. Power Utility Maximization in Constrained Exponential L\'evy Models By Marcel Nutz
  14. "Realized Volatility Risk" By David E. Allen; Michael McAleer; Marcel Scharth
  15. On Asymptotic Power Utility-Based Pricing and Hedging By Jan Kallsen; Johannes Muhle-Karbe; Richard Vierthauer
  16. Preference reversals and disparities between willingness to pay and willingness to accept in repeated markets By Graham Loomes; Chris Starmer; Robert Sugden
  17. Time consistency and moving horizons for risk measures By Samuel N. Cohen; Robert J. Elliott
  18. The generalized index of maximum and minimum level and its application in decision-making By Jose M. Merigo Lindahl; Montserrat Casanovas Ramon

  1. By: Harin, Alexander
    Abstract: The article raises the question of possible existence of ruptures, gaps in the probability scale which are caused by noises, uncertainties. A hypothesis of existence of such ruptures may be used to solve a number of problems of, e.g., utility theory in economics. The calculations give the dimensions of ruptures can be more than 1/3 of the standard deviation for the standard probability distributions.
    Keywords: probability; uncertainty; utility; economics; decisions; risk;
    JEL: D81 E17 D8 C1
    Date: 2009–12–15
  2. By: Moawia, Alghalith
    Abstract: Without imposing restrictions on the utility function and the probability distributions, we show the impact of multiple uncertainty (and each single uncertainty) and change in risk aversion on each input demand. In so doing, we emphasize the importance of the relationship between the inputs in this impact. Moreover, the paper provides technical contributions.
    Keywords: firm; uncertainty; risk; production
    JEL: D21 D81
    Date: 2009–12–14
  3. By: Moawia, Alghalith
    Abstract: We devise an estimation methodology which allows preferences estimation and comparative statics analysis without a reliance on Taylor’s approximations and the indirect utility function.
    Keywords: utility; risk; uncertainty; portfolio; production; estimation
    JEL: C13 D80
    Date: 2009–12–14
  4. By: Kontek, Krzysztof
    Abstract: This short paper demonstrates that the claim of Cumulative Prospect Theory (CPT) that people are risk seeking for loss prospects, which confirmed a hypothetical assumption of the earlier Prospect Theory (PT), appears to be merely a result of using a specific form of the probability weighting function to estimate the power factor of the value function. Using experimental data and the form of the probability weighting function presented by CPT gives a power factor for losses of less than 1. This would mean that people are risk seeking for loss prospects. However, once more flexible, two-parameter forms are used, the power factor takes on values between 1.04 and 1.10. This, however, makes the value function convex, which indicates risk aversion. It follows that people are generally risk averse both for gains and for losses. This contradicts one of the main theses of Prospect Theory.
    Keywords: Prospect Theory; Value Function; Probability Weighting Function; Risk Attitude
    JEL: D81 C91 D87
    Date: 2009–12–14
  5. By: Bradler, Christiane
    Abstract: The literature on social preferences provides overwhelming evidence of departures from pure self-interest of individuals. Experiments show that people care about others' well-being and their relative standing. This paper investigates whether this type of behavior persists when risk comes into play. I devise an experiment which sheds light on the interrelation of risk and social preferences by measuring (1) individual risk preferences, (2) interpersonal risk preferences, and (3) social preferences under certainty. The results reveal that a large share of subjects choose to accept more risk or less potential gain than individually preferred in order to increase another subject's payoff. Further, the willingness to do so appears to be influenced by the need of the other person and her potential relative standing. Surprisingly, the results do not suggest that a subject's social behavior under risk is related to his social concerns exhibited under certainty. --
    Keywords: social preferences,risk,other-regarding behavior,inequality aversion
    JEL: C91 D63 D81
    Date: 2009
  6. By: Blume, Lawrence (Department of Economics, Cornell University, Ithaca, USA); Easley, David (Department of Economics, Cornell University, Ithaca, USA); Halpern, Joseph Y. (Department of Computer Science, Cornell University, Ithaca, USA)
    Abstract: Contemporary approaches to decision making describe a decision problem by sets of states and outcomes, and a rich set of acts: functions from states to outcomes over which the decision maker (DM) has preferences. Real problems do not come so equipped. It is often unclear what the state and outcome spaces would be. We present an alternative foundation for decision making, in which the primitive objects of choice are syntactic programs. We show that if the DM's preference relation on objects of choice satisfies appropriate axioms, then we can find states, outcomes, and an embedding of the programs into Savage acts such that preferences can be represented by EU in the Savage framework. A modeler can test for SEU behavior without having access to the subjective states and outcomes. We illustrate the power of our approach by showing that it can represent DMs who are subject to framing effects.
    Keywords: Decision theory, subjective expected utility, behavioral anomalies
    JEL: D01
    Date: 2009–12
  7. By: Kontek, Krzysztof
    Abstract: This short paper shows that the Allais Paradox and the Common Ratio Effect regarded as classic examples of the violation of the Expected Utility Theory Axioms – may be easily explained by assuming that changes in wealth (i.e. gains and losses) are perceived in relative terms. The preference reversal observed in experiments is therefore predictable and the choices shall consequently be assumed to be rational. By contrast, the assumption that wealth changes are perceived in absolute terms leads to the conclusion that the choices violate the axioms underlying Expected Utility Theory, and are therefore irrational. This state of affairs is called the illusion of irrationality.
    Keywords: Expected Utility Theory; Relative Utility Function; Allais Paradox; Common Ratio Effect; Prospect Theory
    JEL: D81 C91 D87
    Date: 2009–12–06
  8. By: Pasche, Markus
    Abstract: One of Keynes’ core issues in his liquidity preference theory is how fundamental uncertainty affects the propensity to hold money as a liquid asset. The paper critically assesses various formal representations of fundamental uncertainty and provides an argument for a more bounded rational approach to portfolio choice between liquidity and risky assets. The choice is made on the basis of individual beliefs which are subject to mental representations of the underlying economic structure. Self-consciousness arises when the agent is aware of the fact that beliefs are dispersed among agents due to the absence of a “true” model. Responding to this fact by increasing liquidity preference is rationalized by the higher ex post performance of choice. Moreover, we analyze the case that the portfolio is partially financed by debt. It is explored how fundamental uncertainty affects the volume of the portfolio and hence money and credit demand as well as the probability of debt failures. --
    Keywords: Liquidity preference,portfolio choice,self-confidence,self-consciousness,fundamental uncertainty,bounded rationality,Keynes,Knight
    JEL: G11 D81 E41 B31
    Date: 2009
  9. By: Philipp Kircher (Department of Economics, University of Pennsylvania); Sandra Ludwig (Department of Economics, University of Pennsylvania); Alvaro Sandroni (Department of Economics, University of Munich)
    Abstract: We address a basic diffculty with incorporating fairness into standard utilitarian choice theories. Standard utilitarian theories evaluate lotteries according to the (weighted) utility over final outcomes and assume in particular that a lottery is never preferred over getting the most preferred underlying outcome with certainty. While nearly universally adopted in economics (including behavioral economics) and appealing for choices among consumption goods, this approach is problematic when choices directly affect the payoffs of other individuals. A difficulty is that randomization may in itself be valued as a desirable procedure for allocating scarce resources. We highlight this in two simple choice settings. Individuals can choose between three options: to get more money; to get less money and someo ther good; to flip a coin between these two alternatives. When the good is a regular consumption good like a coffeemug, hardly any of our subjects randomize. When the good is a social good that yields payoffs directly to some other individual,nearly a third of our subjects choose to randomize. Our results indicate that fairness concerns are conducive to behavioral anomalies that the standard utilitarian model cannot accommodate.
    Keywords: risky choice, betweenness axiom, social preferences, preference for randomness
    JEL: D81 C91 D63
    Date: 2009–11
  10. By: Dietrich Franz; List Christian (METEOR)
    Abstract: The standard rational choice paradigm explains an individual’s preferences by his beliefs and his fundamental desires. For instance, someone’s preference for joining the army might be explained by certain beliefs about what life in the army is like and a desire for such a life. While beliefs may change (by new information), fundamental desires are totally fixed. One shortcoming of this paradigm is that reasons and motivations play no explicit role. Some of the more fundamental preference changes that one can undergo seem to reach beyond information-learning and to involve a change in the reasons or goals by which one is fundamentally motivated. Such changes of motivating reasons may come in connection with a changing ability to abstractly represent certain aspects of the world (like the thirteenth move in a game) or to imagine certain qualitative aspects of the world (like feelings of complete loneliness). Standard rational choice models implicitly assume away such changes. This paper proposes a formal reason-based model of preferences. The model explains an individual’s preferences by the set of reasons that motivate him. The preference of our example individual for joining the army would be explained by the set of reasons that motivate him, such as service to his country, an athletic body, and comradeship. Preference change in our model thus stems not exclusively from new information but often also from a change of the set of motivating reasons. If our example individual suddenly loses his preference for joining the army and joins a charity, new reasons (such as worldwide justice) might have become motivating while others (such as an athletic body) might have lost their motivational power. Our notion of a ‘(motivating) reason’ is open to different interpretations and applications, like ones related to conceptualisation or imagination abilities. We formulate two natural axioms on reason-based preferences, the first ensuring that preferences are determined by the motivating reasons and the second ensuring that preferences change in a coherent way as additional reasons become motivating. These two axioms are shown to imply a parsimonious representation of preferences: a single binary relation (which ranks the consistent reason sets) is sufficient to generate all individual preferences across possible individual states (i.e., possible sets of motivating reasons).
    Keywords: mathematical economics;
    Date: 2009
  11. By: Louis Kaplow
    Abstract: The possibility that individuals may derive utility from the mere fact of holding wealth has long been recognized. A simple intertemporal model featuring utility from accumulation is used here to examine consumption and savings, the choice between inter vivos gifts and bequests (both to descendants and to charities), and levels of annuitization. Introducing utility from accumulation helps to explain a number of empirical regularities that otherwise seem inconsistent with optimizing behavior. Moreover, because individuals who derive significant utility from accumulation will tend to save more and, in the long run, give more than others do, this source of utility may be especially important in analyzing savings behavior, gifts and bequests, and charitable contributions.
    JEL: D11 D14 D91 H31
    Date: 2009–12
  12. By: Martin L. Weitzman
    Abstract: It is widely recognized that the economics of distant-future events, like climate change, is critically dependent upon the choice of a discount rate. Unfortunately, it is unclear how to discount distant-future events when the future discount rate itself is unknown. In previous work, an analytically-tractable approach called "gamma discounting" was proposed, which gave a declining discount rate schedule as a simple closed-form function of time. This paper extends the previous gamma approach by using a Ramsey optimal growth model, combined with uncertainty about future productivity, in order to "risk adjust" all probabilities by marginal utility weights. Some basic numerical examples are given, which suggest that the overall effect of risk-adjusted gamma discounting on lowering distant-future discount rates may be significant. The driving force is a "fear factor" from risk aversion to permanent productivity shocks representing catastrophic future states of the world.
    JEL: Q54
    Date: 2009–12
  13. By: Marcel Nutz
    Abstract: We study power utility maximization for exponential L\'evy models with portfolio constraints, where utility is obtained from consumption and/or terminal wealth. For convex constraints, an explicit solution in terms of the L\'evy triplet is constructed under minimal assumptions by solving the Bellman equation. We use a novel transformation of the model to avoid technical conditions. The consequences for q-optimal martingale measures are discussed as well as extensions to non-convex constraints.
    Date: 2009–12
  14. By: David E. Allen (School of Accounting, Finance and Economics, Edith Cowan University); Michael McAleer (Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam and Tinbergen Institute); Marcel Scharth (VU University Amsterdam and Tinbergen Institute)
    Abstract: In this paper we document that realized variation measures constructed from high-frequency returns reveal a large degree of volatility risk in stock and index returns, where we characterize volatility risk by the extent to which forecasting errors in realized volatility are substantive. Even though returns standardized by ex post quadratic variation measures are nearly gaussian, this unpredictability brings considerably more uncertainty to the empirically relevant ex ante distribution of returns. Carefully modeling this volatility risk is fundamental. We propose a dually asymmetric realized volatility (DARV) model, which incorporates the important fact that realized volatility series are systematically more volatile in high volatility periods. Returns in this framework display time varying volatility, skewness and kurtosis. We provide a detailed account of the empirical advantages of the model using data on the S&P 500 index and eight other indexes and stocks.
    Date: 2009–12
  15. By: Jan Kallsen; Johannes Muhle-Karbe; Richard Vierthauer
    Abstract: Kramkov and Sirbu (2006, 2007) have shown that first-order approximations of power utility-based prices and hedging strategies can be computed by solving a mean-variance hedging problem under a specific equivalent martingale measure and relative to a suitable numeraire. In order to avoid the introduction of an additional state variable necessitated by the change of numeraire, we propose an alternative representation in terms of the original numeraire. More specifically, we characterize the relevant quantities using semimartingale characteristics similarly as in Cerny and Kallsen (2007) for mean-variance hedging.
    Date: 2009–12
  16. By: Graham Loomes (Department of Economics, University of Warwick); Chris Starmer (School of Economics, University of Nottingham); Robert Sugden (School of Economics, University of East Anglia)
    Abstract: Previous studies suggest that two otherwise robust ‘anomalies’ – preference reversals and disparities between buying and selling valuations – are eroded when respondents participate in repeated markets. We report an experiment which investigates whether this is true when factors neglected in previous studies are controlled, and which distinguishes between anomalies revealed in the behaviour of individual market participants and anomalies revealed in market prices. Our results confirm the decay of buy/sell disparities, but not of preference reversal. This raises doubts about the hypothesis that, in general, repeated markets reveal anomaly-free preferences, even among the marginal traders who determine prices.
    Keywords: preference reversal, willingness to accept, willingness to pay, repeated market
    JEL: C91
    Date: 2009–11
  17. By: Samuel N. Cohen; Robert J. Elliott
    Abstract: Decision making in the presence of randomness is an important problem, particularly in finance. Often, decision makers base their choices on the values of `risk measures' or `nonlinear expectations'; it is important to understand how these decisions evolve through time. In this paper, we consider how these decisions are affected by the use of a moving horizon, and the possible inconsistencies that this creates. By giving a formal treatment of time consistency without Bellman's equations, we show that there is a new sense in which these decisions can be seen as consistent.
    Date: 2009–12
  18. By: Jose M. Merigo Lindahl; Montserrat Casanovas Ramon (Universitat de Barcelona)
    Abstract: We present a new decision-making approach that uses distance measures and induced aggregation operators. We introduce the induced ordered weighted averaging distance (IOWAD) operator, a new aggregation operator that extends the OWA operator by using distance measures and a reordering of the arguments that depends on order-inducing variables. The main advantage of the IOWAD is that it provides a parameterized family of distance aggregation operators between the maximum and the minimum distance based on a complex reordering process that reflects a complex attitudinal character of the decision-maker. We study some of its main properties and particular cases. We develop an application in a decision-making problem regarding the selection of investments. We see that the main advantage of this approach in decision-making is that it is able to provide a more complete picture of the decision process, so the decision-maker is able to select the alternative most in accordance with his interests.
    Keywords: owa operator, hamming distance, induced aggregation operators, decision making
    JEL: C44 D89 C49 D81
    Date: 2009

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