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on Utility Models and Prospect Theory |
| By: | David Dillenberger (Dept. of Economics, University of Pennsylvania); Andrew Postlewaite (Dept. of Economics, University of Pennsylvania); Kareen Rozen (Cowles Foundation, Yale University) |
| Abstract: | Savage (1954) provided a set of axioms on preferences over acts that were equivalent to the existence of an expected utility representation. We show that in addition to this representation, there is a continuum of other "expected utility" representations in which for any act, the probability distribution over states depends on the corresponding outcomes. We suggest that optimism and pessimism can be captured by the stake-dependent probabilities in these alternative representations; e.g., for a pessimist, the probability of every outcome except the worst is distorted down from the Savage probability. Extending the DM's preferences to be defined on both subjective acts and objective lotteries, we show how one may distinguish optimists from pessimists and separate attitude towards uncertainty from curvature of the utility function over monetary prizes. |
| Keywords: | Subjective expected utility, Optimism, Pessimism, Stake-dependent probability |
| JEL: | D80 D81 |
| Date: | 2011–10 |
| URL: | http://d.repec.org/n?u=RePEc:cwl:cwldpp:1829&r=upt |
| By: | Leonard J. Mirman; Marc Santugini |
| Abstract: | Building on Kihlstrom and Mirman (1974)’s formulation of risk aversion in the case of multidimensional utility functions, we study the effect of risk aversion on optimal behavior in a general consumer’s maximization problem under uncertainty. We completely characterize the relationship between changes in risk aversion and classical demand theory. We show that the effect of risk aversion on optimal behavior is determined not by the riskiness of the risky good, but rather the riskiness of the utility gamble associated with each decision. We also discuss the appropriateness of an (alternative) approach to study risk aversion suggested by Selden (1978), which has been widely popularized in the field of macroeconomics through the parametric model of Epstein and Zin (1989) (henceforth, the Selden-EZ approach). We show that the Selden-EZ approach cannot disentangle risk aversion from tastes, and, thus, cannot be used to isolate the effect of risk aversion. |
| Keywords: | Classical Demand Theory, Consumer Choice, Epstein-Zin preferences, Risk Aversion, Selden Preferences |
| JEL: | D01 D81 D91 |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:lvl:lacicr:1132&r=upt |
| By: | Dominiak, Adam; Lefort, Jean-Philippe |
| Abstract: | This paper explores the relationship between dynamic consistency and existing notions of unambiguous events for Choquet expected utility preferences. A decision maker is faced with an information structure represented by a filtration. We show that the decision maker’s preferences respect dynamic consistency on a fixed filtration if and only if the last stage of the filtration is composed of unambiguous events in the sense of Nehring (Math Social Sci 38:197–213, 1999). Adopting two axioms, conditional certainty equivalence consistency and constrained dynamic consistency to filtration measurable acts, it is shown that the decision maker respects these two axioms on a fixed filtration if and only if the last stage of the filtration is made up of unambiguous events in the sense of Zhang (Econ Theory 20:159–181, 2002). |
| Keywords: | Choquet expected utility; Unambiguous events; Filtration; Updating; Dynamic consistency; Consequentialism; |
| JEL: | D81 D82 |
| Date: | 2011–04 |
| URL: | http://d.repec.org/n?u=RePEc:ner:dauphi:urn:hdl:123456789/7323&r=upt |
| By: | Martin Fochmann (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg); Martin Jacob (WHU - Otto Beisheim School of Management) |
| Abstract: | This note develops a behavioral explanation for the existence of an asymmetric tax treatment of gains and losses when investors are loss averse. We find that loss offset rules should be more restrictive for investors which are (1) more risk averse in case of gains, (2) less risk seeking in case of losses, or (3) more loss averse. Our findings have important policy implications. Tax authorities often implement identical loss offset rules for different investor clienteles. However, there should be specific loss offset rules for investors who differ in risk attitude as well as in loss aversion. |
| Keywords: | Asymmetric Taxation, Loss Offset Rules, Loss Aversion, Behavioral Economics |
| Date: | 2011–10 |
| URL: | http://d.repec.org/n?u=RePEc:mag:wpaper:110021&r=upt |
| By: | Zbigniew Palmowski; Sebastian Baran |
| Abstract: | We consider the problem of maximizing the expected utility of discounted dividend payments of an insurance company whose reserves are modeled as a Cram\'er risk process with Erlang claims. We focus on the exponential claims and power and logarithmic utility functions. Finally we also analyze asymptotic behaviour of the value function and identify the asymptotic optimal strategy. We also give the numerical procedure of finding considered value function. |
| Date: | 2011–10 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1110.5446&r=upt |
| By: | Daniel J. Clarke |
| Abstract: | Rational demand for hedging products, where there is a risk of contractual nonperformance, is fundamentally different to that for indemnity insurance. In particular, optimal demand is zero for infinitely risk averse individuals, and is nonmonotonic in risk aversion, wealth and price. For commonly used families of utility functions, demand is hump-shaped in the degree of risk aversion when the price is actuarially unfair, first increasing then decreasing, and either decreasing or decreasing-increasing-decreasing in risk aversion when the price is actuarially favourable. For a given belief, upper bound are derived for the optimal demand from risk averse and decreasing absolute risk averse decision makers. The apparently low level of demand for consumer hedging instruments, particularly from the most risk averse, is explained as a rational response to deadweight costs and the risk of countractual nonperformance. A numerical example is presented for maize in a developing county which suggests that some unsubsidised weather derivatives, currently being designed for and marketed to poor farmers, may in fact be poor products, in that objective financial advice would recommend low or zero purchase from all risk averse expected utility maximisers. |
| Keywords: | Index insurance, Derivative, Basis risk, Hedge, Microinsurance |
| JEL: | D14 D81 G20 O16 |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:oxf:wpaper:572&r=upt |
| By: | Natalia, Khorunzhina; Wayne Roy, Gayle |
| Abstract: | This paper investigates the existence and degree of variation across house holds and over time in the intertemporal elasticity of substitution (IES) and the coefficient of relative risk aversion (RRA) that is generated by habit forming preferences. To do so, we develop a new nonlinear GMM estimator to investigate the presence of habit formation in household consumption using data from the Panel Study of Income Dynamics. Our method accounts for classical measurement errors in consumption without parametric assumptions on the distribution of measurement errors. The estimation results support habit formation in food consumption. Using these estimates, we develop bounds for the expectation of the implied heterogenous intertemporal elasticity of substitution and relative risk aversion that account for measurement errors and compute asymptotically valid confidence intervals on these bounds. We find that these parameters display significant variation across households and over time. |
| Keywords: | Nonlinear models; Classical measurement errors; Habit formation; Intertemporal elasticity of substitution; Relative risk aversion |
| JEL: | C13 D12 D91 C33 E21 |
| Date: | 2011–07 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:34329&r=upt |
| By: | Leonardo Becchetti (Faculty of Economics, University of Rome "Tor Vergata"); Giacomo Degli Antoni (University of Milano - Bicocca); Stefania Ottone (University of Milano - Bicocca); Nazaria Solferino (University of Calabria-Unical) |
| Abstract: | We device a randomized experiment with task performance in which players directly decide allocation criteria (with/without) veil of ignorance on payoff distribution under different criteria in a stakeholder/spectator position. Our main result is a strong and significant gender effect: women choose significantly more protection (that is, they choose criteria in which a part or all the total sum of money that must be allocated among participants is equally distributed) before (but not after) the removal of the veil of ignorance. They also reveal less overconfidence and significantly higher civicness and inequality aversion in ex post questionnaire responses, even though such differences are not enough to fully capture our main result. The puzzle when interpreting it is that the gendered preference for protection exists not only for stakeholders but also for spectators while it disappears for both once we remove the veil of ignorance. This makes it impossible to explain it exclusively with risk or competition aversion. |
| Keywords: | Distributive Justice; Gender Effects; Risk Aversion; Competition Aversion; Veil of Ignorance. |
| JEL: | C91 D63 J16 |
| Date: | 2011–10–24 |
| URL: | http://d.repec.org/n?u=RePEc:rtv:ceisrp:214&r=upt |
| By: | Paola Ferretti (Department of Economics, University Of Venice Cà Foscari); Antonella Campana (Department of Economics, University Of Molise); ; |
| Abstract: | This paper studies excess of loss reinsurance with reinstatements in the case in which the aggregate claims are generated by a discrete distribution, in the framework of risk adjusted premium principle. By regarding to comonotonic exchangeability, a generalized definition of initial premium is proposed and some regularity properties characterizing it are presented, both with reference to conditions on underlying distortion functions both with respect to composing functions. The attention is then focused on conditions ensuring feasibility of generalized initial premiums with reference to the limit on the payment of each claim. |
| Keywords: | Excess of loss reinsurance; reinstatements; initial premium; exchangeability; distortion risk measures; feasibility. |
| JEL: | G22 |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:ven:wpaper:2011_14&r=upt |
| By: | Nicolas Gravel (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); Patrick Moyes (GREThA - Groupe de Recherche en Economie Théorique et Appliquée - CNRS : UMR5113 - Université Montesquieu - Bordeaux IV) |
| Abstract: | We show that it is possible to reconcile the utilitarian and welfarist principles under the requirement of unanimity provided that the set of profiles over which the consensus is attained is rich enough. More precisely, we identify a closedness condition which, if satisfied by a class of n-tuples of utility functions, guarantees that the rankings of social states induced by utilitarian and welfarist unanimities over that class are identical. We illustrate the importance of the result for the measurement of unidimensional as well as multidimensional inequalities from a dominance point of view. |
| Keywords: | Unanimity; Utilitarianism; Welfarism; Stochastic Dominance; Inequality |
| Date: | 2011–10–20 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:halshs-00634010&r=upt |
| By: | S\"oren Christensen |
| Abstract: | In this paper we consider stochastic optimization problems for a risk-avers investor when the decision maker is uncertain about the parameters of the underlying process. In a first part we consider problems of optimal stopping under drift ambiguity for one-dimensional diffusion processes. Analogously to the case of ordinary optimal stopping problems for one-dimensional Brow- nian motions we reduce the problem to the geometric problem of finding the smallest majorant of the reward function in an two-parameter function space. In a second part we solve optimal stopping problems when the underlying process can crash down. These problems are reduced to one optimal stopping problem and one Dynkin game. An explicit example is discussed. |
| Date: | 2011–10 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1110.3897&r=upt |
| By: | R. Anton Braun (Federal Reserve Bank of Atlanta); Tomoyuki Nakajima (Kyoto University) |
| Abstract: | We provide two ways to reconcile small values of the intertemporal elasticity of substitution (IES) that range between 0.35 and 0.5 with empirical evidence that the IES is large. This is done using a model in which all agents have identical preferences and the same access to asset markets. We also conduct an encompassing test. That test indicates that specifications of the model with small values of the IES are more plausible than specifications with a large IES. |
| Keywords: | Uncertainty; Intertemporal elasticity of substitution; Risk aversion; Business Cycles; Growth. |
| JEL: | E21 E32 O41 |
| Date: | 2011–10 |
| URL: | http://d.repec.org/n?u=RePEc:kyo:wpaper:788&r=upt |
| By: | Selda (Ying Fang) Kao; K. Vela Velupillai |
| Abstract: | In this paper, the origins and development of behavioural economics, beginning with the pioneering works of Herbert Simon (1953) and Ward Edwards (1954), is traced, described and (critically) discussed, in some detail. Two kinds of behavioural economics – classical and modern – are attributed, respectively, to the two pioneers. The mathematical foundations of classical behavioural economics is identified, largely, to be in the theory of computation and computational complexity; the corresponding mathematical basis for modern behavioural economics is, on the other hand, claimed to be a notion of subjective probability (at least at its origins in the works of Ward Edwards). The economic theories of behavior, challenging various aspects of 'orthodox' theory, were decisively influenced by these two mathematical underpinnings of the two theories |
| Keywords: | Classical Behavioural Economics, Modern Behavioural Economics, Subjective Probability, Model of Computation, Computational Complexity. Subjective Expected Utility |
| JEL: | C61 C63 D81 D83 |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:trn:utwpas:1126&r=upt |
| By: | Fabian Gouret (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I); Guillaume Hollard (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) |
| Abstract: | To understand how decisions to invest in stocks are taken, economists need to elicit expectations relative to expected risk-return trade-off. One of the few surveys which have included such questions is the Survey of Economic Expectations in 1999-2001. Using this survey, Dominitz and Manski find an important heterogeneity across respondents that can hardly be accounted for by simple models of expectations formation. This paper claims that much of the heterogeneity derives from pathologies affecting respondents. Adapting a principle of dual-reasoning borrowed from Kahneman, we classify respondents according to their sensitivity to these pathologies, and find a strong homogeneity across the less sensitive respondents. We then sketch a model of expectation formation |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:hal-00633561&r=upt |
| By: | Schilirò , Daniele |
| Abstract: | Classical mathematical algorithms often fail to identify in time when the international financial crises occur although, as the classical theory of choice would suggest, the economic agents are rational and the markets are or should be efficient and behave also rationally. This contribution does not pretend to give a complete answer to these questions, but it will highlight some well-known limits of the classical theory of rational choice and compare this theory of choice with the approach that seeks to combine economics and psychology and that has established itself as cognitive or behavioral economics. In particular, the present paper will focus on the juxtaposition of the concepts of perfect rationality and bounded rationality. It concludes with some references to the literature of behavioral finance which has given important contributions in explaining the behavior and the anomalies of financial markets. |
| Keywords: | Bounded rationality; procedural rationality; rational choice; cognitive economics |
| JEL: | D81 B52 C00 D83 |
| Date: | 2011–10 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:34292&r=upt |
| By: | Humphreys, Brad (University of Alberta, Department of Economics); Perez, Levi (University of Oviedo) |
| Abstract: | Government sponsored lotteries operate around the world. Their popularity has grown substantially over time. Legal lottery gambling generates significant public revenue, much of it from the lower part of the income distribution. Lottery is almost always an unfair bet, so explaining the purchase of lottery tickets by risk-averse consumers has long challenged economic theory. Lotteries can be analyzed from the perspective of public finance, as source of public revenue, or consumer theory, as a consumer commodity. We survey the state of economic research on lotteries from both perspectives, focusing on the key empirical findings. |
| Keywords: | lottery; implicit tax; effective price; jackpot; conscious selection |
| JEL: | D12 H30 L83 |
| Date: | 2011–10–01 |
| URL: | http://d.repec.org/n?u=RePEc:ris:albaec:2011_017&r=upt |