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on Utility Models and Prospect Theory |
| By: | Donald J. Brown (Department of Economics, Yale University); Chandra Erdman (U.S. Bureau of the Census); Kirsten Ling (Office of the Controller of the Currency); Laurie Santos (Department of Psychology, Yale University) |
| Abstract: | We replicate the essentials of the Huettel et al. (2006) experiment on choice under uncertainty with 30 Yale undergraduates, where subjects make 200 pair-wise choices between risky and ambiguous lotteries. Inferences about the independence of economic preferences for risk and ambiguity are derived from estimation of a mixed logit model, where the choice probabilities are functions of two random effects: the proxies for risk-aversion and ambiguity-aversion. Our principal empirical finding is that we cannot reject the null hypothesis that risk and ambiguity are independent in economic choice under uncertainty. This finding is consistent with the hypothesized independence of the neural mechanisms governing economic choices under risk and ambiguity, suggested by the double dissociation-fMRI study reported in Huettel et al. |
| Keywords: | Mixed logit, Risk-aversion, Ambiguity-aversion |
| JEL: | C14 C25 C91 D81 |
| Date: | 2010–11 |
| URL: | http://d.repec.org/n?u=RePEc:cwl:cwldpp:1774&r=upt |
| By: | Berg, Nathan; Eckel, Catherine; Johnson, Cathleen |
| Abstract: | Experimental choice data from 881 subjects based on 40 time-tradeoff items and 32 risky choice items reveal that most subjects are time-inconsistent and most violate the axioms of expected utility theory. These inconsistencies cannot be explained by well-known theories of behavioral inconsistency, such as hyperbolic discounting and cumulative prospect theory. Aggregating expected payoffs and the risk associated with each subjects’ 72 choice items, the statistical links between inconsistency and total payoffs are reported. Time-inconsistent subjects and those who violate expected utility theory both earn substantially higher expected payoffs, and these positive associations survive largely undiminished when included together in total payoff regressions. Consistent subjects earn lower than average payoffs because most of them are consistently impatient or consistently risk averse. Positive payoffs from inconsistency cannot, however, be fully explained by greater risk taking. Controlling for the total risk of each subject’s risk choices as well as for socio-economic differences among subjects, time inconsistent subjects earn significantly more money, in statistical and economic terms. So do expected utility violators. Positive returns to inconsistency extend outside the domain in which inconsistencies occurs, with time-inconsistent subjects earning more on risky choice items, and expected utility violators earning more on time-tradeoff items. The results seem to call into question whether axioms of internal consistency—and violations of these axioms that behavioral economists frequently focus on—are economically relevant criteria for evaluating the quality of decision making in human populations. |
| Keywords: | behavioral economics; hyperbolic discounting; hypobolic; normative; coherence; correspondence; consistency; irrationality; rationality |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:26589&r=upt |
| By: | David Roubaud (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - CNRS : UMR6579); André Lapied (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - CNRS : UMR6579); Robert Kast (LAMETA - Laboratoire Montpellierain d'économie théorique et appliquée - CNRS : UMR5474 - INRA : UR1135 - CIHEAM - Université Montpellier I - Montpellier SupAgro) |
| Abstract: | Real options models characterized by the presence of ambiguity have been recently proposed. But based on recursive multiple-priors approaches to solve ambiguity, these seminal models reduce individual preferences to extreme pessimism by considering only the worst case scenario. In contrast, by relying on dynamically consistent Choquet-Brownian motions to model the dynamics of ambiguous expected cash flows, we show that a much broader spectrum of attitudes towards ambiguity may be accounted for. In the case of a perpetual real option to invest, ambiguity aversion delays the moment of exercise of the option, while the opposite holds true for an ambiguity lover. |
| Keywords: | Real Options; Ambiguity; Irreversible investment; Optimal stopping; Knightian uncertainty; Choquet-Brownian motions |
| Date: | 2010–11–08 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:halshs-00534027_v1&r=upt |
| By: | Günter Franke (Department of Economics, University of Konstanz, Germany); Ferdinand Graf (Department of Economics, University of Konstanz, Germany) |
| Abstract: | In the continuous time-Merton-model the instantaneous stock proportions are inversely proportional to the investor’s local relative risk aversion γ. This paper analyses the conditions under which a HARA-investor can use this 1/γ-rule to approximate her optimal portfolio in a finite time setting without material effects on the certainty equivalent of the portfolio payoff. The approximation is of high quality if approximate arbitrage opportunities do not exist and if the investor’s relative risk aversion is higher than that used for deriving the approximation portfolio. Otherwise, the approximation quality may be bad. |
| Keywords: | HARA-utility, portfolio choice, certainty equivalent, approximated choice |
| JEL: | G10 G11 D81 |
| Date: | 2010–11–04 |
| URL: | http://d.repec.org/n?u=RePEc:knz:dpteco:1011&r=upt |
| By: | Fabian Herweg (University of Bonn); Daniel Müller (University of Bonn); Philipp Weinschenk (Max Planck Institute for Research on Collective Goods) |
| Abstract: | We modify the principal-agent model with moral hazard by assuming that the agent is expectation-based loss averse according to Köszegi and Rabin (2006, 2007). The optimal contract is a binary payment scheme even for a rich performance measure, where standard preferences predict a fully contingent contract. The logic is that, due to the stochastic reference point, increasing the number of different wages reduces the agent’s expected utility without providing strong additional incentives. Moreover, for diminutive occurrence probabilities for all signals the agent is rewarded with the fixed bonus if his performance exceeds a certain threshold. |
| JEL: | D82 M12 M52 |
| Date: | 2010–09 |
| URL: | http://d.repec.org/n?u=RePEc:mpg:wpaper:2010_38&r=upt |
| By: | Gaffeo, E.; Petrella, I.; Pfajfar, D.; Santoro, E. (Tilburg University, Center for Economic Research) |
| Abstract: | This paper proposes a novel explanation of the vast empirical evidence showing that output and prices react asymmetrically to monetary policy innovations over contractions and expansions in the business cycle. We use VAR techniques to show that monetary policy exerts stronger e¤ects on the U.S. GDP during contractionary phases, as compared to expansionary ones. As to prices, their response is not statistically different across different cyclical stages. We show that these facts are consistent with a New Neoclassical Synthesis model based on the assumption that households' utility partly depends on deviations of their consumption from a reference level below which aversion to loss is displayed. In line with the theory developed by Kahneman and Tversky (1979), losses in consumption utility loom larger than gains. This implies state-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption that generate competing effects on the responses of output and inflation following a monetary innovation. The key predictions of the model are in line with the data. We then explore the state-dependent trade-o¤ between inflation and output stabilization that naturally arises in this context. Greater elasticity of inflation to real activity during expansionary stages of the cycle promotes a stronger degree of policy activism in the response to the expected rate of inflation under discretion, compared to what is otherwise prescribed during contractions. |
| Keywords: | Reference-dependent Preferences;Asymmetry;Monetary policy. |
| JEL: | E32 E52 D11 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:dgr:kubcen:2010111&r=upt |
| By: | Robert Kast (LAMETA - Laboratoire Montpellierain d'économie théorique et appliquée - CNRS : UMR5474 - INRA : UR1135 - CIHEAM - Université Montpellier I - Montpellier SupAgro); André Lapied (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - CNRS : UMR6579) |
| Abstract: | In the real investments literature, the investigated cash flow is assumed to follow some known stochastic process (e.g. Brownian motion) and the criterion to decide between investments is the discounted utility of their cash flows. However, for most new investments the investor may be ambiguous about the representation of uncertainty. In order to take such ambiguity into account, we refer to a discounted Choquet expected utility in our model. In such a setting some problems are to dealt with: dynamical consistency, here it is obtained in a recursive model by a weakened version of the axiom. Mimicking the Brownian motion as the limit of a random walk for the investment payoff process, we describe the latter as a binomial tree with capacities instead of exact probabilities on its branches and show what are its properties at the limit. We show that most results in the real investments literature are tractable in this enlarged setting but leave more room to ambiguity as both the mean and the variance of the underlying stochastic process are modified in our ambiguous model |
| Keywords: | Choquet integrals; conditional Choquet integrals; random walk; Brownian motion; real options; optimal portfolio |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:halshs-00533826_v1&r=upt |
| By: | Quah, John K.-H.; Strulovici, Bruno |
| Abstract: | We identify a natural way of ordering functions, which we call the interval dominance order and develop a theory of monotone comparative statics based on this order. This way of ordering functions is weaker than the standard one based on the single crossing property (Milgrom and Shannon, 1994) and so our results apply in some settings where the single crossing property does not hold. For example, they are useful when examining the comparative statics of optimal stopping time problems. We also show that certain basic results in statistical decision theory which are important in economics - specifically, the complete class theorem of Karlin and Rubin (1956) and the results connected with Lehmann’s (1988) concept of informativeness - generalize to payoff functions obeying the interval dominance order. |
| JEL: | F11 D11 G11 D21 C61 |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:ner:oxford:http://economics.ouls.ox.ac.uk/14981/&r=upt |
| By: | Astrid Matthey (Max Planck Institute of Economics, Jena, Germany); Tobias Regner (Max Planck Institute of Economics, Jena, Germany) |
| Abstract: | We investigate to what extent genuine social preferences can explain observed other-regarding behavior. In a dictator game variant subjects can choose whether to learn about the consequences of their choice for the receiver. We find that a majority of subjects showing other-regarding behavior when the payoffs of the receiver are known, choose to ignore these consequences if possible. This behavior is inconsistent with preferences about outcomes. Other-regarding behavior may also be explained by avoiding cognitive dissonance as in Konow (2000). Our experiment's choice data is in line with this approach. In addition, we successfully relate individual behavior to proxies for cognitive dissonance. |
| Keywords: | social preferences, other-regarding behavior, experiments, social dilemma, cognitive dissonance |
| JEL: | C72 D01 C91 D80 |
| Date: | 2010–11–11 |
| URL: | http://d.repec.org/n?u=RePEc:jrp:jrpwrp:2010-077&r=upt |
| By: | Marina Bianchi (University of Cassino) |
| Date: | 2010–04 |
| URL: | http://d.repec.org/n?u=RePEc:css:wpaper:2010-04&r=upt |