nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2011‒02‒19
eight papers chosen by
Alexander Harin
Modern University for the Humanities

  1. History-Dependent Risk Attitude By David Dillenberger; Kareen Rozen
  2. Differences between Decision and Experienced Utility: An Investigation using the Choice Experiment method By Colombo, Sergio; Hanley, Nick; Tinch, Dugald
  3. Bounded Rationality By Penelope Hernandez; Coralio Ballester
  4. Term premia and the news By Michael D. Bauer
  5. How wrong can you be? Implications of incorrect utility function specification for welfare measurement in choice experiments By Hanley, Nick; Riera, Antoni; Torres, Cati
  6. Optimal Life Insurance Purchase, Consumption and Investment on a financial market with multi-dimensional diffusive terms By I. Duarte; D. Pinheiro; A. A. Pinto; S. R. Pliska
  7. Asymptotic properties of weighted least squares estimation in weak parma models By Francq, Christian; Roy, Roch; Saidi, Abdessamad
  8. Errors in Variables and the Empirics of Economic Growth By Jean-Louis Arcand; Marcel Dagenais

  1. By: David Dillenberger (Department of Economics, University of Pennsylvania); Kareen Rozen (Department of Economics, Yale University and Cowles Foundation for Research in Economics)
    Abstract: We propose a model of history-dependent risk attitude (HDRA), allowing the attitude of a decision-maker (DM) towards risk at each stage of a T-stage lottery to evolve as a function of his history of disappointments and elations in prior stages. We establish an equivalence between the existence of an HDRA representation and two documented cognitive biases. First, the DM’s risk attitudes are reinforced by prior experiences: he becomes more risk averse after suffering a disappointment and less risk averse after being elated. Second, the DM displays a primacy effect: early outcomes have the strongest effect on risk attitude. Furthermore, the DM lowers his threshold for elation after a disappointing outcome and raises it after an elating outcome; this makes disappointment more likely after elation and vice-versa, leading to statistically reversing risk attitudes. “Gray areas” in the elation-disappointment assignment are connected to optimism and pessimism in determining endogenous reference points.
    Keywords: history-dependent risk attitude, statistically reversing risk attitudes, reinforcement effect, primacy effect, endogenous reference dependence, betweenness, optimism, pessimism
    JEL: D81 D91
    Date: 2011–02–14
  2. By: Colombo, Sergio; Hanley, Nick; Tinch, Dugald
    Abstract: Recent work by Kahneman and others has led to a new focus in economics on a wellbeing-based approach to utility. This suggests that ‘experienced utility' is an alternative and more appropriate basis for the measurement of economic value compared with ‘decision utility'. In this paper, we apply the choice experiment technique to the valuation of changes in upland landscapes in the UK, in order to identify if experience in the moment or in memory impacts on the value associated with changes in ecosystem services under different management regimes. Four treatments are employed to measure decision utility, experienced utility, and remembered utility at two different time intervals. We show that our experienced utility treatment generates very different estimates of preferences than any of the other treatments. Whilst measurement of experienced utility is rife with difficulties, the approach taken allowed the identification of experiential impacts on utility and may have implications for the future use of experienced utility as a basis for the valuation of public goods.
    Keywords: national parks; public goods; choice experiments; cost-benefit analysis; experienced utility
    Date: 2010–11
  3. By: Penelope Hernandez (ERI-CES); Coralio Ballester (University Alicante)
    Abstract: The observation of the actual behavior by economic decision makers in the lab and in the field justifies that bounded rationality has been a generally accepted assumption in many socio-economic models. The goal of this paper is to illustrate the difficulties involved in providing a correct definition of what a rational (or irrational) agent is. In this paper we describe two frameworks that employ different approaches for analyzing bounded rationality. The first is a spatial segregation set-up that encompasses two optimization methodologies: backward induction and forward induction. The main result is that, even under the same state of knowledge, rational and non-rational agents may match their actions. The second framework elaborates on the relationship between irrationality and informational restrictions. We use the beauty contest (Nagel, 1995) as a device to explain this relationship.
    Keywords: Behavioral economics, bounded rationality, partial information
    JEL: C61 C73
    Date: 2011–01
  4. By: Michael D. Bauer
    Abstract: How do monetary policy expectations and term premia respond to news? This paper provides new answers to this question by means of a dynamic term structure model (DTSM) in which risk prices are restricted. This leads to more precise and more reliable estimates of expectations and term premium components. I provide a new econometric framework for DTSM estimation that allows the researcher to select plausible constraints from a large set of restrictions, to correctly quantify statistical uncertainty, and to incorporate model uncertainty in the inference about risk pricing. The main empirical result is that under the restrictions favored by the data the expectations component, and not the term premium, accounts for the majority of high-frequency movements of long-term interest rates and for essentially all of their procyclical response to macroeconomic news. At both high and low frequencies, term premia are more stable than implied by a DTSM with unconstrained risk prices. The apparent disconnect between long-term rates and policy rates that has puzzled macroeconomists for some time is resolved by appropriately restricting the risk adjustment in models for bond pricing.
    Keywords: Bonds - Prices ; Interest rates
    Date: 2011
  5. By: Hanley, Nick; Riera, Antoni; Torres, Cati
    Abstract: Despite the vital role of the utility function in welfare measurement, the implications of working with incorrect utility specifications have been largely neglected in the choice experiments literature. This paper addresses the importance of specification with a special emphasis on the effects of mistaken assumptions about the marginal utility of income. Monte Carlo experiments were conducted using different functional forms of utility to generate simulated choices. Multi-Nomial Logit and Mixed Logit models were then estimated on these choices under correct and incorrect assumptions about the true, underlying utility function. Estimated willingness to pay measures from these choice modelling results are then compared with the equivalent measures directly calculated from the true utility specifications. Results show that for the parameter values and functional forms considered, a continuous-quadratic or a discrete-linear attribute specification is a good option regardless of the true effects the attribute has on utility. We also find that mistaken assumptions about preferences over costs magnify attribute mis-specification effects.
    Keywords: Monte Carlo analysis; choice experiments; efficiency; accuracy; welfare measurement; attributes; utility specification
    Date: 2010–11
  6. By: I. Duarte; D. Pinheiro; A. A. Pinto; S. R. Pliska
    Abstract: We introduce an extension to Merton's famous continuous time model of optimal consumption and investment, in the spirit of previous works by Pliska and Ye, to allow for a wage earner to have a random lifetime and to use a portion of the income to purchase life insurance in order to provide for his estate, while investing his savings in a financial market comprised of one risk-free security and an arbitrary number of risky securities driven by multi-dimensional Brownian motion. We then provide a detailed analysis of the optimal consumption, investment, and insurance purchase strategies for the wage earner whose goal is to maximize the expected utility obtained from his family consumption, from the size of the estate in the event of premature death, and from the size of the estate at the time of retirement. We use dynamic programming methods to obtain explicit solutions for the case of discounted constant relative risk aversion utility functions and describe new analytical results which are presented together with the corresponding economic interpretations.
    Date: 2011–02
  7. By: Francq, Christian; Roy, Roch; Saidi, Abdessamad
    Abstract: The aim of this work is to investigate the asymptotic properties of weighted least squares (WLS) estimation for causal and invertible periodic autoregressive moving average (PARMA) models with uncorrelated but dependent errors. Under mild assumptions, it is shown that the WLS estimators of PARMA models are strongly consistent and asymptotically normal. It extends Theorem 3.1 of Basawa and Lund (2001) on least squares estimation of PARMA models with independent errors. It is seen that the asymptotic covariance matrix of the WLS estimators obtained under dependent errors is generally different from that obtained with independent errors. The impact can be dramatic on the standard inference methods based on independent errors when the latter are dependent. Examples and simulation results illustrate the practical relevance of our findings. An application to financial data is also presented.
    Keywords: Weak periodic autoregressive moving average models; Seasonality; Weighted least squares; Asymptotic normality; Strong consistency; Weak periodic white noise; Strong mixing.
    JEL: C22
    Date: 2011–02–01
  8. By: Jean-Louis Arcand (CERDI - Centre d'études et de recherches sur le developpement international - CNRS : UMR6587 - Université d'Auvergne - Clermont-Ferrand I); Marcel Dagenais (CERDI - Centre d'études et de recherches sur le developpement international - CNRS : UMR6587 - Université d'Auvergne - Clermont-Ferrand I)
    Abstract: We examine cross-sectional empirical evidence on the determinants of economic growth in light of an instrumental variables estimator, based on sample moments of order higher than two, which does not require extraneous instruments and which remains consistent, under quite reasonable assumptions, when measurement errors affect the explanatory variables. We focus on several in‡fluential papers — Barro (1991), Mankiw, Romer, and Weil (1992), Sachs and Warner (1997a), Easterly and Levine (1997), Levine and Zervos (1998)— and find that many of their results are “fragile”. We argue that the application of our estimator to cross-sectional empirical studies of the determinants of growth yields important insights which may qualify previous findings in the literature, especially given the errors in variables problems which are known to plague commonly used cross-sectional datasets.
    Keywords: errors in variables;economic growth
    Date: 2011–02–09

This nep-upt issue is ©2011 by Alexander Harin. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.