
on Utility Models and Prospect Theory 
By:  Olivier Chanel (GREQAM  Groupement de Recherche en Économie Quantitative d'AixMarseille  Université de la Méditerranée  AixMarseille II  Université Paul Cézanne  AixMarseille III  Ecole des Hautes Etudes en Sciences Sociales (EHESS)  CNRS : UMR6579); Graciela Chichilnisky (Department of Statistics  Columbia University) 
Abstract:  Global environmental phenomena like climate change, major extinction events or flutype pandemics can have catastrophic consequences. By properly assessing the outcomes involved  especially those concerning human life  economic theory of choice under uncertainty is expected to help people take the best decision. However, the widely used expected utility theory values life in terms of the low probability of death someone would be willing to accept in order to receive extra payment. Common sense and experimental evidence refute this way of valuing life, and here we provide experimental evidence of people's unwillingness to accept a low probability of death, contrary to expected utility predictions. This work uses new axioms of choice, especially an axiom that allows extreme responses to extreme events, and the choice criterion that they imply. The implied decision criteria are a combination of expected utility with extreme responses, and seem more consistent with observations. 
Keywords:  Decision under risk; Value of Prevented Fatality; Expected Utility; Experiment; Catastrophic risk 
Date:  2011–12–13 
URL:  http://d.repec.org/n?u=RePEc:hal:wpaper:halshs00651163&r=upt 
By:  Gwenola Trotin (EQUIPPE); Amedeo Piolatto (Universidad de Alicante) 
Abstract:  Prospect Theory (PT) has become the most credited alternative to Expected Utility Theory (EUT) as a theory of decision under uncertainty. This paper characterizes the optimal income tax and audit schemes under tax evasion, when taxpayers behave as predicted by PT. We show that the standard EUT results keep holding under PT, under even weaker conditions. Under fair assumptions on the reference income and on the utility function of taxpayers, we show that the optimal audit probability function is nonincreasing and the optimal tax function is nondecreasing and concave. 
Keywords:  Tax evasion; Income tax enforcement; Prospect theory 
JEL:  D81 H26 K42 
Date:  2011–12 
URL:  http://d.repec.org/n?u=RePEc:ivi:wpasad:201124&r=upt 
By:  He, Haoran (School of Economics and Business Administration, Beijing Normal University); Martinsson, Peter (Department of Economics, School of Business, Economics and Law, Göteborg University); Sutter, Matthias (Dept of Public Finance, University of Innsbruck) 
Abstract:  In an experiment, we study risktaking of cohabitating student couples, finding that couples’ decisions are closer to riskneutrality than single partners’ decisions. This finding is similar to earlier experiments with randomly assigned groups, corroborating external validity of earlier results. 
Keywords:  risk experiment; student couples; group decision making 
JEL:  C91 C92 
Date:  2011–12–15 
URL:  http://d.repec.org/n?u=RePEc:hhs:gunwpe:0519&r=upt 
By:  Pierpaolo Battigalli; Simone CerreiaVioglio; Fabio Maccheroni; Massimo Marinacci 
Abstract:  We propose to bring together two conceptually complementary ideas: (1) selfconfi?rming equilibrium (SCE): at a rest point of learning dynamics in a game played recurrently, agents best respond to confi?rmed beliefs, i.e. beliefs consistent with the evidence they accumulate, and (2) ambiguity aversion: agents, coeteris paribus, prefer to bet on events with known rather than unknown probabilities, more generally, agents distinguish objective from subjective uncertainty, which is captured by their ambiguity attitudes. Using as a workhorse the ?smooth ambiguity model of Klibanoff, Marinacci and Mukerji (2005), we provide a de?nition of "smooth SCE" which generalizes the traditional concept of Fudenberg and Levine (1993a,b), called Bayesian SCE, and admits Waldean (maxmin) SCE as a limit case. We show that the set of equilibria expands as ambiguity aversion increases. The intuition is simple: by playing the same "statusquo" strategy in a stable state an agent learns the implied objective probabilities of payoffs, but alternative strategies yield payoffs with unknown probabilities; keeping beliefs ?fixed, increased aversion to ambiguity makes such strategies less appealing. We rely on this core intuition to show that different notions of equilibrium are nested in a simple way, from ?ner to coarser: Nash, Bayesian SCE, Smooth SCE and Waldean SCE. We also prove some equivalence results, under special assumptions about the information structure. 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:igi:igierp:428&r=upt 
By:  Masako Ikefuji; Roger J. A. Laeven; Jan R. Magnus; Chris Muris 
Abstract:  We specify a stochastic economyclimate model, adapting Nordhaus' deterministic economyclimate model by allowing for Weitzmantype stochasticity. We show that, under expected power utility, the model is fragile to heavytailed distributional assumptions and we derive necessary and sufficient conditions on the utility function to avoid fragility. We solve our stochastic economyclimate model for two cases with compatible pairs of utility functions and heavytailed distributional assumptions. We further develop and implement a procedure to learn the input parameters of our model and show that the model thus specified produces robust optimal policies. The numerical results indicate that higher levels of uncertainty lead to less abatement and consumption, and to more investment. 
Date:  2011–12 
URL:  http://d.repec.org/n?u=RePEc:dpr:wpaper:0825&r=upt 
By:  Ulrich Witt; Martin Binder 
Abstract:  Although decision makers are often reported to have difficulties in making comparisons between multidimensional decision outcomes, economic theory assumes a unidimensional utility measure. This paper reviews evidence from behavioral and brain sciences to assess whether, and for what reasons, this assumption may be warranted. It is claimed that the decision makers' difficulties can be explained once the motivational aspects of utility ("wanting") are disentangled from the experiential ones ("liking") and the features of the different psychological processes involved are recognized. 
Keywords:  utility, neuroeconomics, index number problem, wanting, liking, affective, forecasting 
JEL:  D87 B41 B12 
Date:  2011–12–22 
URL:  http://d.repec.org/n?u=RePEc:esi:evopap:201120&r=upt 
By:  O’Callaghan, Patrick (University of Warwick) 
Abstract:  Suppose a decisionmaker is willing to make statements of the form : I prefer to choose alternative a when in context p, than to choose alternative b when in context q”. Contexts p and q may refer to given probability distributions over a set of states, and b and c to alternatives such as: “turn left” or “turn right” at a junction. In such decision problems, the set of alternatives is discrete and there is a continuum of possible contexts. I assume there is a is a mixture operation on the space of contexts (eg. convex combinations of lotteries), and propose a model that defines preferences over a collection of mixture spaces indexed by a discrete set. The model yields a spectrum of possibilities: some decisionmakers are well represented by a standard von Neumann–Morgenstern type of utility function; whilst for others, utility across some or all the mixture spaces is only ordinally comparable. An application to the decision problem of Karni and Safra (2000) leads to a generalization, and shows that statedependence and comparability are distinct concepts. A final application provides a novel way modeling incomplete preferences and explaining the Allais paradox. 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:wrk:warwec:973&r=upt 
By:  Kai Christoffel (European Central Bank, Kaiserstrasse 29, D60311 Frankfurt am Main, Germany.); Ivan Jaccard (European Central Bank, Kaiserstrasse 29, D60311 Frankfurt am Main, Germany.); Juha Kilponen (Bank of Finland, Rauhankatu 19, FI00101 Helsinki, Finland and European Financial Stability Facility.) 
Abstract:  We introduce a specification of habit formation featuring nonseparability between consumption and leisure into an otherwise standard New Keynesian model. The model can be estimated with standard Bayesian techniques and the bond pricing implications are evaluated using higherorder approximations. The model is able to reproduce a sizeable risk premium on longterm bonds and the cyclicality of fiscal policy has an impact on the bond premium that is quantitatively important. Technology, government spending, and markup shocks are the main drivers of the timevariation in bond premia. JEL Classification: E5, E6, G1. 
Keywords:  DSGE models, fiscal policy, bond risk premium, monetary policy. 
Date:  2011–12 
URL:  http://d.repec.org/n?u=RePEc:ecb:ecbwps:20111411&r=upt 
By:  Marco Cozzi (Queen's University) 
Abstract:  This paper considers the macroeconomic implications of a set of empirical studies finding a high degree of dispersion in preference heterogeneity. It develops a model with both uninsurable idiosyncratic income risk and risk aversion heterogeneity to quantify their effects on wealth inequality. The results show that with the available estimates of the risk aversion distribution from PSID data the model can match the observed degree of wealth inequality in the U.S., accounting for the wealth Gini index in several cases. The model replicates well several features of the wealth distribution. However, the share of wealth held by the top 1% is still substantially underestimated. It is also shown that models without risk aversion heterogeneity underestimate the size of precautionary savings, and that the results are robust to both different income process specifications and to selfselection into risky jobs. 
Keywords:  Wealth Inequality, Heterogeneous Agents, Incomplete Markets, Computable General Equilibrium 
JEL:  E21 D52 D58 C68 
Date:  2011–12 
URL:  http://d.repec.org/n?u=RePEc:qed:wpaper:1286&r=upt 
By:  Shangzhen Luo; Michael Taksar 
Abstract:  In this paper, we study a risk process modeled by a Brownian motion with drift (the diffusion approximation model). The insurance entity can purchase reinsurance to lower its risk and receive cash injections at discrete times to avoid ruin. Proportional reinsurance and excessofloss reinsurance are considered. The objective is to find the optimal reinsurance and cash injection strategy that minimizes the total cost to keep the company's surplus process nonnegative, i.e. without ruin, where the cost function is defined as the total discounted value of the injections. The optimal solution is found explicitly by solving the according quasivariational inequalities (QVIs). 
Date:  2011–12 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1112.4005&r=upt 