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on Utility Models and Prospect Theory |
| By: | Rothe, Jorn |
| Abstract: | This paper formulates a rationality concept for extensive games in which deviations from rational play are interpreted as evidence of irrationality. Instead of confirming some prior belief about the nature of nonrational play, we assume that such a deviation leads to genuine uncertainty. Assuming complete ignorance about the nature of non-rational play and extreme uncertainty aversion of the rational players, we formulate an equilibrium concept on the basis of Choquet expected utility theory. Equilibrium reasoning is thus only applied on the equilibrium path, maximin reasoning applies off the equilibrium path. The equilibrium path itself is endogenously determined. In general this leads to strategy profiles differ qualitatively from sequential equilibria, but still satisfy equilibrium and perfection requirements. In the centipede game and the finitely repeated prisoners’ dilemma this approach can also resolve the backward induction paradox. |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:ner:lselon:http://eprints.lse.ac.uk/37541/&r=upt |
| By: | Mark Dean; Daniel Martin |
| Abstract: | In this paper, we introduce a new measure of how close a set of choices are to satisfying the observable implications of rational choice, and apply it to a large balanced panel of household level consumption data. We use this method to answer three related questions: (i) "How close are individual consumption choices to satisfying the model of utility maximization?" (ii) "Are there di¤erences in rationality between di¤erent demographic groups?" (iii) "Can choices be aggregated across individuals under the assumption of homogeneous preferences?" Crucially, in answering these questions, we take into account the power of budget sets faced by each household to expose failures of rationality. To summarize our results we ?nd that: (i) while observed violations of rationality are small in absolute terms, our households are only moderately more rational than the benchmark of random choice; (ii) there are signi?cant di¤erences in the rationality of di¤erent groups, with multi-head households more rational than single head households, and the youngest households more rational than middle age households; (iii) the assumption of homogenous preferences is strongly rejected: choice data that is aggregated across households exhibits high levels of irrationality. |
| Keywords: | # |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:bro:econwp:2011-11&r=upt |
| By: | Gerdes, Christer (SOFI, Stockholm University); Gränsmark, Patrik (SOFI, Stockholm University); Rosholm, Michael (Aarhus School of Business) |
| Abstract: | We examine rational learning among expert chess players and how they update their beliefs in repeated games with the same opponent. We present a model that explains how equilibrium play is affected when players change their choice of strategy when receiving additional information from each encounter. We employ a large international panel dataset with controls for risk preferences and playing skills whereby the latter accounts for ability. Although expert chess players are intelligent, productive and equipped with adequate data and specialized computer programs, we find large learning effects. Moreover, as predicted by the model, risk-averse players learn substantially faster. |
| Keywords: | rational learning, risk aversion, beliefs |
| JEL: | C73 D83 |
| Date: | 2011–07 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp5862&r=upt |
| By: | Bert WILLEMS; Joris MORBEE |
| Abstract: | In this paper we show that free entry decisions may be socially inefficient, even in a perfectly competitive homogeneous goods market with non-lumpy investments. In our model, inefficient entry decisions are the result of risk-aversion of incumbent producers and consumers, combined with incomplete financial markets which limit risk-sharing between market actors. Investments in productive assets affect the distribution of equilibrium prices and quantities, and create risk spillovers. From a societal perspective, entrants underinvest in technologies that would reduce systemic sector risk, and may overinvest in risk-increasing technologies. The inefficiency is shown to disappear when a complete financial market of tradable risk-sharing instruments is available, although the introduction of any individual tradable instrument may actually decrease efficiency. We therefore believe that sectors without well-developed financial markets will benefit from sector-specific regulation of investment decisions. |
| Date: | 2011–05 |
| URL: | http://d.repec.org/n?u=RePEc:ete:ceswps:ces11.17&r=upt |
| By: | Ilyana Kuziemko; Ryan W. Buell; Taly Reich; Michael I. Norton |
| Abstract: | Why do low-income individuals often oppose redistribution? We hypothesize that an aversion to being in "last place" undercuts support for redistribution, with low-income individuals punishing those slightly below themselves to keep someone "beneath" them. In laboratory experiments, we find support for "last-place aversion" in the contexts of risk aversion and redistributive preferences. Participants choose gambles with the potential to move them out of last place that they reject when randomly placed in other parts of the distribution. Similarly, in money- transfer games, those randomly placed in second-to-last place are the least likely to costlessly give money to the player one rank below. Last-place aversion predicts that those earning just above the minimum wage will be most likely to oppose minimum-wage increases as they would no longer have a lower-wage group beneath them, a prediction we confirm using survey data. |
| JEL: | C91 D31 D72 H23 I3 J38 |
| Date: | 2011–07 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:17234&r=upt |
| By: | Ronnie Sircar; Stephan Sturm |
| Abstract: | The left tail of the implied volatility skew, coming from quotes on out-of-the-money put options, can be thought to reflect the market's assessment of the risk of a huge drop in stock prices. We analyze how this market information can be integrated into the theoretical framework of convex monetary measures of risk. In particular, we make use of indifference pricing by dynamic convex risk measures, which are given as solutions of backward stochastic differential equations (BSDEs), to establish a link between these two approaches to risk measurement. We derive a characterization of the implied volatility in terms of the solution of a nonlinear PDE and provide a small time-to-maturity expansion and numerical solutions. This procedure allows to choose convex risk measures in a conveniently parametrized class, distorted entropic dynamic risk measures, which we introduce here, such that the asymptotic volatility skew under indifference pricing can be matched with the market skew. |
| Date: | 2011–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1107.4632&r=upt |
| By: | Federica Teppa |
| Abstract: | This paper provides new evidence on individual preferences over annuities and lump sum payments based on hypothetical questions posed in the DNB Household Survey in 2005. Contrary to the majority of papers in the annuitization puzzle literature, this study allows to control explicitly for the subjective survival probability (SSP), a key driver of the decision about whether to annuitize or not as a perceived measure of longevity risk. We find that people expecting to live longer do claim to prefer the annuity. This finding is very robust to controlling for bequest motives. The relevance of this paper is twofold. First, it delivers an important empirical result on the role of the SSP that is still not directly tested in the literature. Second and more important, combined with the empirical evidence that on average individuals tend to systematically underestimate their life expectancy, the findings have strong policy implications. The annuitization puzzle may be alleviated by helping individuals in better assessing their longevity risk, rather than forcing their actions. |
| Keywords: | Longevity Risk; Annuitization Puzzle; Survey Data; Hypothetical Choices |
| JEL: | C5 C8 D12 G11 |
| Date: | 2011–07 |
| URL: | http://d.repec.org/n?u=RePEc:dnb:dnbwpp:302&r=upt |
| By: | Kousky, Carolyn; Kopp, Robert E.; Cooke, Roger |
| Abstract: | Reducing greenhouse gas emissions not only lowers expected damages from climate change but also reduces the risk of catastrophic impacts. However, estimates of the social cost of carbon, which measures the marginal value of carbon dioxide abatement, often do not capture this risk reduction benefit. Risk-averse individuals are willing to pay a risk premium, an additional amount beyond the difference in expected damages, to reduce risks. The authors review methods used and estimates obtained for calculating a risk premium to be included in the social cost of carbon. While more research is needed in this area, work to date suggests a positive risk premium on the social cost of carbon is warranted. -- |
| Keywords: | Climate change,social cost of carbon,risk premium |
| JEL: | Q54 |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:ifwedp:201119&r=upt |
| By: | Henry Dannenberg |
| Abstract: | This article seeks to make an assessment of estimation uncertainty in a multi-rating class loan portfolio. Relationships are established between estimation uncertainty and parameters such as probability of default, intra- and inter-rating class correlation, degree of inhomogeneity, number of rating classes used, number of debtors and number of historical periods used for parameter estimations. In addition, by using an exemplary portfolio based on Moody’s ratings, it becomes clear that estimation uncertainty does indeed have an effect on interest rates. |
| Keywords: | credit portfolio risk, estimation uncertainty, bootstrapping, economic equity |
| JEL: | C15 D81 G11 |
| Date: | 2011–07 |
| URL: | http://d.repec.org/n?u=RePEc:iwh:dispap:11-11&r=upt |
| By: | De Luca, G.; Magnus, J.R. (Tilburg University, Center for Economic Research) |
| Abstract: | This article is concerned with the estimation of linear regression models with uncertainty about the choice of the explanatory variables. We introduce the Stata commands bma and wals which implement, respectively, the exact Bayesian Model Averaging (BMA) estimator and the Weighted Average Least Squares (WALS) estimator developed by Magnus et al. (2010). Unlike standard pretest estimators which are based on some preliminary diagnostic test, these model averaging estimators provide a coherent way of making inference on the regression parameters of interest by taking into account the uncertainty due to both the estimation and the model selection steps. Special emphasis is given to a number practical issues that users are likely to face in applied work: equivariance to certain transformations of the explanatory variables, stability, accuracy, computing speed and out-of-memory problems. Performances of our bma and wals commands are illustrated using simulated data and empirical applications from the literature on model averaging estimation. |
| Keywords: | Model uncertainty;Model averaging;Bayesian analysis;Exact computation. |
| JEL: | C11 C51 C52 |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:dgr:kubcen:2011082&r=upt |