
on Utility Models and Prospect Theory 
By:  Ulrich Schmidt; Horst Zank 
Abstract:  In previous models of (cumulative) prospect theory referencedependence of preferences is imposed beforehand and the location of the reference point is exogenously determined. This note provides a foundation of prospect theory, where referencedependence is derived from preference conditions and a unique reference point arises endogenously 
Keywords:  Prospect theory, reference point, diminishing sensitivity, loss aversion 
JEL:  D81 
Date:  2010–03 
URL:  http://d.repec.org/n?u=RePEc:kie:kieliw:1611&r=upt 
By:  Antoine Bommier (GREMAQ  Groupe de recherche en économie mathématique et quantitative  CNRS : UMR5604  Université des Sciences Sociales  Toulouse I  Ecole des Hautes Etudes en Sciences Sociales (EHESS)); Arnold Chassagnon (LEDASDFi  LEDASDFi  Université Paris Dauphine  Paris IX); François Legrand (EMLyon Business School  EMLYON Business School) 
Abstract:  We consider a formal approach to comparative risk aversion and applies it to intertemporal choice models. This allows us to ask whether standard classes of utility functions, such as those inspired by Kihlstrom and Mirman (1974), Selden (1978), Epstein and Zin (1989) and Quiggin (1982) are wellordered in terms of risk aversion. Moreover, opting for this modelfree approach allows us to establish new general results on the impact of risk aversion on savings behaviors. In particular, we show that risk aversion enhances precautionary savings, clarifying the link that exists between the notions of prudence and risk aversion. 
Date:  2010–01–28 
URL:  http://d.repec.org/n?u=RePEc:hal:wpaper:hal00451281_v1&r=upt 
By:  John Cotter (School of Business, University College Dublin); Jim Hanly (School of Accounting and Finance, Dublin Institute of Technology) 
Abstract:  Risk aversion is a key element of utility maximizing hedge strategies; however, it has typically been assigned an arbitrary value in the literature. This paper instead applies a GARCHinMean (GARCHM) model to estimate a timevarying measure of risk aversion that is based on the observed risk preferences of energy hedging market participants. The resulting estimates are applied to derive explicit risk aversion based optimal hedge strategies for both short and long hedgers. Outofsample results are also presented based on a unique approach that allows us to forecast risk aversion, thereby estimating hedge strategies that address the potential future needs of energy hedgers. We find that the risk aversion based hedges differ significantly from simpler OLS hedges. When implemented insample, risk aversion hedges for short hedgers outperform the OLS hedge ratio in a utility based comparison. 
Keywords:  Energy, Hedging, Risk Management, Risk Aversion, Forecasting 
JEL:  G10 G12 G15 
Date:  2010–01–01 
URL:  http://d.repec.org/n?u=RePEc:ucd:wpaper:201007&r=upt 
By:  Chiaki Hara (Institute of Economic Research, Kyoto University) 
Abstract:  In an exchange economy under uncertainty populated by consumers having constant and equal relative risk aversion but heterogeneous probabilistic beliefs, we analyze the nature of the representative consumer's probabilistic belief and discount rates. We prove a formula that implies that the representative consumer's discount rates are raised or lowered by belief heterogeneity depending on whether the constant relative risk aversion is greater or smaller than one. We also show that the representative consumer's discount rates may be a hyperbolic function of time even when the individual consumers' discount rates are equal to one another, as long as their beliefs are heterogeneous. 
Keywords:  Representative consumer, expected utility, hyperbolic discounting, constant relative risk aversion, Ito's Lemma, Girsanov's Theorem 
JEL:  D51 D53 D81 D91 G12 G13 Q51 Q54 
Date:  2010–03 
URL:  http://d.repec.org/n?u=RePEc:kyo:wpaper:701&r=upt 
By:  Francisco MartínezMora; M. Socorro Puy 
Abstract:  We study the political consequences of policy preferences which are nonsymmetric around the peak. While the usual assumption of symmetric preferences is innocuous in political equilibria with platforms convergence, it is not neutral when candidates are differentiated. We show that a larger government size emerges when preferences of the median voter offthepeak are more intense towards overprovision (what we call wasteful preferences), whereas a smaller government results when her preferences are more intense towards underprovision (scrooge preferences). We then analyze the determinants of preferences offthepeak and find that: (i) The sign of the third derivative of the policyinduced utility function indicates whether preferences are wasteful (positive) or scrooge (negative). (ii) The analog of Kimball's coefficient of prudence can be used to measure degrees of wastefulness and scroogeness. (iii) Consumers' risk aversion and government decreasing effectiveness in producing the public good generate scrooge. 
Keywords:  Singlepeaked preferences; citizencandidate; coefficient of prudence; differentiated platforms; riskaversion 
JEL:  D72 H31 H5 
Date:  2010–01 
URL:  http://d.repec.org/n?u=RePEc:lec:leecon:10/04&r=upt 
By:  Pavlo R. Blavatskyy 
Abstract:  The results of a new experimental study reveal highly systematic violations of expected utility theory. The pattern of these violations is exactly the opposite of the classical common ratio effect discovered by Allais (1953). Two recent decision theories— stochastic expected utility theory (Blavatskyy, 2007) and perceived relative argument model (Loomes, 2008)—predicted the existence of a reverse common ratio effect. However, these theories can rationalize only one part of the new experimental data reported in this paper. The other part appears to be neither predicted by existing theories nor documented in the existing empirical studies. 
Keywords:  Expected utility theory, common ratio effect, Allais paradox, risk, experiment 
JEL:  C91 D81 
Date:  2010–02 
URL:  http://d.repec.org/n?u=RePEc:zur:iewwpx:478&r=upt 
By:  Heiko Karle (Université Libre de Bruxelles); Martin Peitz (University of Mannheim) 
Abstract:  We develop a theory of imperfect competition with lossaverse consumers. All consumers are fully informed about match value and price at the time they make their purchasing decision. However, a share of consumers are initially uncertain about their tastes and form a reference point consisting of an expected match value and an expected price distribution, while other consumers are perfectly informed all the time. We derive pricing implications in duopoly with asymmetric ﬁrms. In particular, we show that a market may exhibit more price variation the larger the share of uninformed, lossaverse consumers. We also derive implications for ﬁrm strategy and public policy concerning ﬁrms’ incentives to inform consumers about their match value prior to forming their reference point. 
Keywords:  Loss Aversion, ReferenceDependent Utility, Information Disclosure, Price Variation, Advertising, Behavioral Industrial Organization, Imperfect Compe tition, Product Diﬀerentiation 
JEL:  D83 L13 L41 M37 
Date:  2010–04 
URL:  http://d.repec.org/n?u=RePEc:trf:wpaper:312&r=upt 
By:  RoseAnne 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 PanthéonSorbonne  Paris I, EEPPSE  Ecole d'Économie de Paris  Paris School of Economics  Ecole d'Économie de Paris, University of Exeter Business School  University of Exeter Business School) 
Abstract:  The theory of existence of equilibrium with shortselling 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 agents, the more likely are efficient allocations and equilibria to exist. 
Keywords:  Uncertainty, risk, common prior, equilibria with shortselling. Variational preferences 
Date:  2010 
URL:  http://d.repec.org/n?u=RePEc:hal:cesptp:halshs00470670_v1&r=upt 
By:  Lindsey, Robin (University of Alberta, Department of Economics) 
Abstract:  Demand and capacity fluctuations are common for roads and other congestible facilities. With ongoing advances in pricing technology and ways of communicating information to prospective users, statedependent congestion pricing is becoming increasingly practical. But it is still rare or nonexistent in many potential applications. One explanation is that people dislike uncertainty about how much they will pay. To explore this idea a model of referencedependent preferences is developed based on Koszegi and Rabin (2006). Using a facility yields an "intrinsic" utility and a "gainloss" utility measured relative to the probability distribution over states of utility outcomes. Two types of preferences are analyzed: bundled preference in which gains and losses are perceived for overall utility, and unbundled preferences in which gains and losses are perceived separately for the toll and other determinants of utility. <p> Tolls are chosen to maximize total expected utility plus revenues. With bundled preferences the toll is set above the Pigouvian level when usage conditions are good, and below it when conditions are bad, to reduce gains and losses from fluctuations in utility. With unbundled preferences the direction of toll adjustment is less clear and depends on whether supply or demand is variable. For both types of preferences tolls are sensitive to the strength of gainloss utility. If a gainloss utility is moderately strong, a stateindependent toll can be optimal. 
Keywords:  congestion pricing; statedependent pricing; referencedependent preferences 
JEL:  D81 R41 
Date:  2010–01–01 
URL:  http://d.repec.org/n?u=RePEc:ris:albaec:2010_004&r=upt 
By:  Zafer Akin 
Date:  2010–02 
URL:  http://d.repec.org/n?u=RePEc:tob:wpaper:1001&r=upt 
By:  Oxoby, Robert J. (University of Calgary); Morrison, William G. (Wilfrid Laurier University) 
Abstract:  We present results from a laboratory study of loss aversion in the context of intertemporal choice. We investigate whether the provision of (windfall) endowments results in different elicited discount rates relative to subjects who earn income or earn and retain the income for a period before making intertemporal decisions. We hypothesize that loss aversion in an intertemporal choice yields higher discount rates among subjects earning and retaining. Our results support this hypothesis: among subjects who earn and retain their income we elicit substantially higher discount rates relative to those experiencing a windfall gain. 
Keywords:  intertemporal choice, discount rates, experiments 
JEL:  C91 D91 
Date:  2010–03 
URL:  http://d.repec.org/n?u=RePEc:iza:izadps:dp4854&r=upt 
By:  Tobias Berg (Technische Universität München, Department of Financial Management and Capital Markets, Arcisstr. 21, 80290 Munich, Germany.) 
Abstract:  This study calibrates the term structure of risk premia before and during the 2007/2008 financial crisis using a new calibration approach based on credit default swaps. The risk premium term structure was flat before the crisis and downward sloping during the crisis. The instantaneous risk premium increased significantly during the crisis, whereas the longrun mean of the risk premium process was of the same magnitude before and during the crisis. These findings suggest that (marginal) investors have become more risk averse during the crisis. Investors were, however, well aware that risk premia will revert back to normal levels in the long run. JEL Classification: G12, G13. 
Keywords:  credit risk, risk premia, equity premium, mean reversion, structural models of default. 
Date:  2010–03 
URL:  http://d.repec.org/n?u=RePEc:ecb:ecbwps:20101165&r=upt 
By:  Simon Grant (Department of Economics, Rice University); Jeff Kline (Department of Economics, University of Queensland); John Quiggin (Department of Economics, University of Queensland) 
Abstract:  We present a formal treatment of contracting in the face of ambiguity. The central idea is that boundedly rational individuals will not always interpret the same situation in the same way. More specifically, even with well defined contracts, the precise actions to be taken by each party to the contract might be disputable. Taking this potential for dispute into account, we analyze the effects of ambiguity on contracting. We find that risk averse agents will engage in ambiguous contracts for risk sharing reasons. We provide an application where ambiguity motivates the use of a liquidated damages contract. 
Keywords:  ambiguity, bounded rationality, expected uncertain utility, incomplete contracts, liquidated damages. 
JEL:  D80 D82 
Date:  2009–11 
URL:  http://d.repec.org/n?u=RePEc:rsm:riskun:r09_3&r=upt 
By:  Aleksey Tetenov 
Abstract:  This paper studies the problem of treatment choice between a status quo treatment with a known outcome distribution and an innovation whose outcomes are observed only in a representative finite sample. I evaluate statistical decision rules, which are functions that map sample outcomes into the planner’s treatment choice for the population, based on regret, which is the expected welfare loss due to assigning inferior treatments. I extend previous work that applied the minimax regret criterion to treatment choice problems by considering decision criteria that asymmetrically treat Type I regret (due to mistakenly choosing an inferior new treatment) and Type II regret (due to mistakenly rejecting a superior innovation). I derive exact finite sample solutions to these problems for experiments with normal, Bernoulli and bounded distributions of individual outcomes. In conclusion, I discuss approaches to the problem for other classes of distributions. Along the way, the paper compares asymmetric minimax regret criteria with statistical decision rules based on classical hypothesis tests. 
Keywords:  treatment effects, loss aversion, statistical decisions, hypothesis testing. 
JEL:  C44 C21 C12 
Date:  2009 
URL:  http://d.repec.org/n?u=RePEc:cca:wpaper:119&r=upt 
By:  Christina Kotakou (Department of Economics, University of Macedonia); Stelios Katranidis (Department of Economics, University of Macedonia) 
Abstract:  This paper examines the effects of decoupling policies on Greek cotton production under the hypothesis that producers face uncertainty about output price and quantity. Using our estimation results we simulate the effects on cotton production under four alternative policy scenarios: the ‘Old’ CAP regime (i.e. the policy practiced until 2005), the Mid Term Review regime, a fully decoupled policy regime and a free tradeno policy scenario. Our results indicate the decoupled payment will have two contradictious effects on risk aversion. Producers become less risk averse through the wealth effect but more risk averse because of the increased output variance. The overall result of these two effects depends on the degree of risk aversion by farmers. We found that when the degree of risk aversion is high the wealth effect is positive. However, in the case of low risk aversion, the wealth disappears in practice and as a result the decoupled payments become production neutral. 
Keywords:  Common Agricultural Policy, decoupling, uncertainty 
JEL:  D21 Q18 
Date:  2010–04 
URL:  http://d.repec.org/n?u=RePEc:mcd:mcddps:2010_04&r=upt 
By:  Sophie Bade (Max Planck Institute for Research on Collective Goods, Bonn) 
Abstract:  A gametheoretic framework that allows for explicitly randomized strategies is used to study the effect of ambiguity aversion on equilibrium outcomes. The notions of "independent strategies" as well as of "common priors" are amended to render them applicable to games in which players lack probabilistic sophistication. Within this framework the equilibrium predictions of two player games with ambiguity averse and with ambiguity neutral players are observationally equivalent. This equivalence result does not extend to the case of games with more than two players. A translation of the concept of equilibrium in beliefs to the context of ambiguity aversion yields substantially dierent predictions – even for the case with just two players. 
Keywords:  Uncertainty Aversion, Nash Equilibrium, Ambiguity 
JEL:  C72 D81 
Date:  2010–03 
URL:  http://d.repec.org/n?u=RePEc:mpg:wpaper:2010_09&r=upt 
By:  Michael H. Birnbaum; Ulrich Schmidt; Miriam D. Schneider 
Abstract:  This paper presents an experimental test of several independence conditions implied by expected utility and alternative models. We perform a repeated choice experiment and fit an error model that allows us to discriminate between true violations of independence and those that can be attributed to errors. In order to investigate the role of event splitting effects, we present each choice problem not only in coalesced form (as in most previous studies) but also in split form. It turns out previously reported violations of independence and splitting effects remain significant even when controlling for errors. Splitting effects have a substantial influence on the tests of independence conditions. When choices are presented in canonical split form, in which probabilities on corresponding probabilityconsequence ranked branches are equal, violations of the independence conditions we tested become either reversed, insignificant or unsystematic 
Keywords:  Independence axiom, splitting effects, coalescing, errors, experiment 
JEL:  C91 D81 
Date:  2010–03 
URL:  http://d.repec.org/n?u=RePEc:kie:kieliw:1614&r=upt 
By:  Andersson, Jonas (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration); Ubøe, Jan (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration) 
Abstract:  In this paper we give a survey on some basic ideas related to random utility, extreme value theory and multinomial logit models. These ideas are well known within the field of spatial economics, but do not appear to be common knowledge to researchers in probability theory. The purpose of the paper is to try to bridge this gap. 
Keywords:  Random utility theory; extreme value theory; multinomial logit models; entropy. 
JEL:  C50 
Date:  2010–01–15 
URL:  http://d.repec.org/n?u=RePEc:hhs:nhhfms:2010_001&r=upt 
By:  Michael H. Birnbaum; Ulrich Schmidt 
Abstract:  This paper tests Birnbaum’s (2004) theory that the constant consequence paradoxes of Allais are due to violations of coalescing, the assumption that when two branches lead to the same consequence, they can be combined by adding their probabilities. Rank dependent utility and cumulative prospect theory imply that the Allais paradoxes are due to violations of restricted branch independence, a weaker form of Savage’s sure thing axiom. This paper will analyze separately whether erroneous random response variation might be responsible for these two effects. When errors are factored out, violations of restricted branch independence also remain significant and opposite from the direction of Allais paradoxes, suggesting that models such as CPT that attribute Allais paradoxes to violations of restricted branch independence should be rejected 
Keywords:  Independence axiom, splitting effects, coalescing, errors, experiment 
JEL:  C91 D81 
Date:  2010–03 
URL:  http://d.repec.org/n?u=RePEc:kie:kieliw:1615&r=upt 
By:  Jules H. van Binsbergen (Graduate School of Business, Stanford University); Jesús FernándezVillaverde (Department of Economics, University of Pennsylvania); Ralph S.J. Koijen (Booth School of Business, University of Chicago); Juan F. RubioRamírez (Department of Economics, Duke University) 
Abstract:  We solve a dynamic stochastic general equilibrium (DSGE) model in which the representative household has Epstein and Zin recursive preferences. The parameters governing preferences and technology are estimated by means of maximum likelihood using macroeconomic data and asset prices, with a particular focus on the term structure of interest rates. We estimate a large risk aversion, an elasticity of intertemporal substitution higher than one, and substantial adjustment costs. Furthermore, we identify the tensions within the model by estimating it on subsets of these data. We conclude by pointing out potential extensions that might improve the model’s fit. 
Keywords:  DSGE models, EpsteinZin preferences, likelihood estimation, yield curve 
JEL:  E30 G12 
Date:  2010–03–01 
URL:  http://d.repec.org/n?u=RePEc:pen:papers:10011&r=upt 
By:  Kazuo Nishimura (Institute of Economic Research, Kyoto University); Alain Venditti (CNRS  GREQAM and EDHEC) 
Abstract:  We consider a continuoustime twosector innitehorizon model with sector specic externalities, endogenous labor and a concave homogeneous nonseparable utility function. We show that local indeterminacy arises with a low elasticity of intertempo ral substitution in consumption provided the wage elasticity of the labor supply and the elasticity of substitution between consumption and leisure are low enough. Such a result cannot hold with additivelyseparable preferences for which local indeterminacy requires a large enough elasticity of intertemporal substitution in consumption. 
Keywords:  Sectorspecic externalities, endogenous labor, nonseparable concave ho mogeneous utility functions, intertemporal substitution in consumption, local indetermi nacy. 
JEL:  C62 E32 O41 
Date:  2010–03 
URL:  http://d.repec.org/n?u=RePEc:kyo:wpaper:702&r=upt 
By:  Jules van Binsbergen; Jesús FernándezVillaverde; Ralph S.J. Koijen; Juan F. RubioRamírez 
Abstract:  We solve a dynamic stochastic general equilibrium (DSGE) model in which the representative household has Epstein and Zin recursive preferences. The parameters governing preferences and technology are estimated by means of maximum likelihood using macroeconomic data and asset prices, with a particular focus on the term structure of interest rates. We estimate a large risk aversion, an elasticity of intertemporal substitution higher than one, and substantial adjustment costs. Furthermore, we identify the tensions within the model by estimating it on subsets of these data. We conclude by pointing out potential extensions that might improve the model's fit. 
JEL:  E2 E3 G12 
Date:  2010–04 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:15890&r=upt 
By:  Graham Loomes (University of Warwick); José Luis PintoPrades (Department of Economics,Universidad Pablo de Olavide); Jose Maria AbellanPerpinan (U. de Murcia); Eva RodriguezMiguez (U. de Vigo) 
Abstract:  When individuals take part in decision experiments, their answers are typically subject to some degree of noise / error / imprecision. There are different ways of modelling this stochastic element in the data, and the interpretation of the data can be altered radically, depending on the assumptions made about the stochastic specification. This paper presents the results of an experiment which gathered data of a kind that has until now been in short supply. These data strongly suggest that the 'usual' (Fechnerian) assumptions about errors are inappropriate for individual decision experiments. Moreover, they provide striking evidence that core preferences display systematic departures from transitivity which cannot be attributed to any 'error' story. 
Keywords:  Error Imprecision Preferences Transitivity 
JEL:  C44 C91 
Date:  2010–02 
URL:  http://d.repec.org/n?u=RePEc:pab:wpaper:10.03&r=upt 
By:  De Graeve, Ferre (Research Department, Central Bank of Sweden); Dossche, Maarten (National Bank of Belgium); Emiris, Marina (Bank of Canada); Sneessens, Henri (University of Luxembourg); Wouters, Raf (National Bank of Belgium) 
Abstract:  We analyze financial risk premiums and real economic dynamics in a DSGE model with three types of agents  shareholders, bondholders and workers  that differ in participation in the capital market and in attitude towards risk and intertemporal substitution. Aggregate productivity and distribution risks are transferred across these agents via the bond market and via an efficient labor contract. The result is a combination of volatile returns to capital and a highly cyclical consumption process for the shareholders, which are two important ingredients for generating high and countercyclical risk premiums. These risk premiums are consistent with a strong propagation mechanism through an elastic supply of labor, rigid real wages and a countercyclical labor share. Based on the empirical estimates for the two sources of real macroeconomicrisk, the model generates significant and plausible time variation in both bond and equity risk premiums. Interestingly, the single largest jump in both the risk premium and the price of risk is observed during the current recession. 
Keywords:  MacroFinance; Heterogeneous agent; Limited participation; Equity premium; Bond premium 
JEL:  E32 E44 G12 
Date:  2010–01–01 
URL:  http://d.repec.org/n?u=RePEc:hhs:rbnkwp:0236&r=upt 