nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2011‒08‒09
nine papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Explaining the harmonic sequence paradox By Ulrich Schmidt; Alexander Zimper
  2. Risk preferences under heterogeneous environmental risk By Roland Olbrich; Martin F. Quaas; Andreas Haensler; Stefan Baumgaertner
  3. Real Estate Portfolio Management : Optimization under Risk Aversion By Fabrice Barthelemy; Jean-Luc Prigent
  4. Risk and the role of collateral in debt renegotiation By Neus, Werner; Stadler, Manfred
  5. What drives failure to maximize payoffs in the lab ? A test of the inequality aversion hypothesis By Nicolas Jacquemet; Adam Zylbersztejn
  6. Properties of Foreign Exchange Risk Premiums By Sarno, Lucio; Schneider, Paul; Wagner, Christian
  7. The marginal utility of money: A modern Marshallian approach to consumer choice By József Sákovics and Daniel Friedman (University of California at Santa Cruz)
  8. Voting on income-contingent loans for higher education By Elena Del Rey; Maria Racionero
  9. Health Insurance without Single Crossing: why healthy people have high coverage By Boone, Jan; Schottmüller, Christoph

  1. By: Ulrich Schmidt; Alexander Zimper
    Abstract: According to the harmonic sequence paradox (Blavatskyy 2006), an expected utility decision maker's willingness-to-pay for a gamble whose expected payoffs evolve according to the harmonic series is finite if and only if his marginal utility of additional income becomes zero for rather low payoff levels. Since the assumption of zero marginal utility is implausible for finite payoffs levels, expected utility theory—as well as its standard generalizations such as cumulative prospect theory—are apparently unable to explain a finite willingness-to-pay. The present paper presents first an experimental study of the harmonic sequence paradox. Additionally, it demonstrates that the theoretical argument of the harmonic sequence paradox only applies to time-patient decision makers whereas the paradox is easily avoided if time-impatience is introduced
    Keywords: St. Petersburg Paradox, Expected Utility, Time-Preferences
    JEL: C91 D81
    Date: 2011–08
  2. By: Roland Olbrich (Department of Sustainability Sciences and Department of Economics, Leuphana University of Lueneburg, Germany); Martin F. Quaas (Department of Economics, University of Kiel, Germany); Andreas Haensler (Terrestrial Hydrology Group, Max-Planck-Institute for Meteorology, Hamburg, Germany); Stefan Baumgaertner (Department of Sustainability Sciences and Department of Economics, Leuphana University of Lueneburg, Germany)
    Abstract: We study risk preferences and their determinants for commercial cattle farmers in Namibia who are subject to high and heterogeneous precipitation risk, using data from questionnaire and field experiments, simulated data for on-farm precipitation risk and data on famers’ previous place of residence. We find that the relationship between risk preferences and precipitation risk is contingent on early-life experience with this risk. We also find that adult farmers self-select themselves onto farms according to their risk preferences. Results are not confounded by background risks or liquidity constraint.
    Keywords: risk preferences, environmental risk, experimental elicitation, endogenous preferences, self-selection, field experiment
    JEL: D81 Q12 Q57
    Date: 2011–08
  3. By: Fabrice Barthelemy; Jean-Luc Prigent (THEMA, Universite de Cergy-Pontoise; THEMA, Universite de Cergy-Pontoise)
    Abstract: This paper deals with real estate portfolio optimization when investors are risk averse. In this framework, we determine several types of optimal times to sell a diversified real estate and analyze their properties. The optimization problem corresponds to the maximization of a concave utility function defined on the terminal value of the portfolio. We extend previous results (Baroni et al., 2007, and Barthélémy and Prigent, 2009), established for the quasi linear utility case, where investors are risk neutral. We consider four cases. In the first one, the investor knows the probability distribution of the real estate index. In the second one, the investor is perfectly informed about the real estate market dynamics. In the third case, the investor uses an intertemporal optimization approach which looks like an American option problem. Finally, the buy-and-hold strategy is considered. For these four cases we analyze numerically the solutions that we compare with those of the quasi linear case. We show that the introduction of risk aversion allows to better take account of the real estate market volatility. We also introduce the notion of compensating variation to better compare all these solutions.
    Keywords: Real estate portfolio, Optimal holding period, Risk aversion, Real estate market volatility
    JEL: C61 G11 R21
    Date: 2011
  4. By: Neus, Werner; Stadler, Manfred
    Abstract: In his basic model of debt renegotiation, BESTER [1994] argues that collateral is more effective if high risk projects are financed. This result, however, crucially depends on the definition of risk. Using the second-order stochastic dominance criterion introduced by ROTHSCHILD AND STIGLITZ [1970], we show that it is not a project's high risk, induced by a high probability of default, that makes collateral more effective. Instead it turns out that, given the expected return, the probability of default has no impact on the collateral's effectiveness. Moreover, a higher risk of the project caused by a higher loss given default makes the use of collateral even less effective. --
    Keywords: Debt renegotiation,Collateral,Risk,Stochastic dominance
    JEL: D81 D82 G21 G32
    Date: 2011
  5. By: Nicolas Jacquemet (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris); Adam Zylbersztejn (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I)
    Abstract: In experiments based on the Beard and Beil (1994) game, second movers very often fail to select the decision that maximizes both players payoff. This note reports on a new experimental treatment, in which we neutralize the potential effect of inequality aversion on the likelihood of this behavior. We show this behavior is robust to this change, even after allowing for repetition-based learning.
    Keywords: Coordination failure, laboratory experiments, aversion to inequality.
    Date: 2011–06
  6. By: Sarno, Lucio; Schneider, Paul; Wagner, Christian
    Abstract: We study the properties of foreign exchange risk premiums that can explain the forward bias puzzle, defined as the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premiums arise endogenously from the no-arbitrage condition relating the term structure of interest rates and exchange rates. Estimating affine (multi-currency) term structure models reveals a noticeable tradeoff between matching depreciation rates and accuracy in pricing bonds. Risk premiums implied by our global affine model generate unbiased predictions for currency excess returns and are closely related to global risk aversion, the business cycle, and traditional exchange rate fundamentals.
    Keywords: exchange rates; forward bias; predictability; term structure
    JEL: E43 F31 G10
    Date: 2011–08
  7. By: József Sákovics and Daniel Friedman (University of California at Santa Cruz)
    Abstract: We reformulate neoclassical consumer choice by focusing on lamda, the marginal utility of money. As the opportunity cost of current expenditure, lamda is approximated by the slope of the indirect utility function of the continuation. We argue that lamda can largely supplant the role of an arbitrary budget constraint in partial equilibrium analysis. The result is a better grounded, more flexible and more intuitive approach to consumer choice.
    Keywords: budget constraint, separability, value for money
    JEL: D01 D11
    Date: 2011–08–02
  8. By: Elena Del Rey; Maria Racionero
    Abstract: We consider risk-averse individuals who differ in two characteristics - ability to benefit from education and inherited wealth - and analyze higher education participation under two alternative financing schemes - tax subsidy and (risk-sharing) income-contingent loans. With decreasing absolute risk aversion, wealthier individuals are more likely to undertake higher education despite the fact that, according to the stylized financing schemes we consider, individuals do not pay any up-front financial cost of education. We then determine which financing scheme arises when individuals are allowed to vote between schemes. We show that the degree of risk aversion plays a crucial role in determining which financing scheme obtains a majority, and that the composition of the support group for each financing scheme can be of two different types.
    JEL: H52 I22 D72
    Date: 2011–07
  9. By: Boone, Jan; Schottmüller, Christoph
    Abstract: Standard insurance models predict that people with high (health) risks have high insurance coverage. It is empirically documented that people with high income have lower health risks and are better insured. We show that income differences between risk types lead to a violation of single crossing in the standard insurance model. If insurers have some market power, this can explain the empirically observed outcome. This observation has also policy implications: While risk adjustment is traditionally viewed as an intervention which increases efficiency and raises the utility of low health agents, we show that with a violation of single crossing a trade off between efficiency and solidarity emerges.
    Keywords: health insurance; risk adjustment; single crossing
    JEL: D82 I11
    Date: 2011–08

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