nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2012‒01‒03
ten papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Valuing life: experimental evidence using sensitivity to rare events By Olivier Chanel; Graciela Chichilnisky
  2. Optimal tax enforcement under prospect theory By Gwenola Trotin; Amedeo Piolatto
  3. Group Decision Making Under Risk: An experiment with student couples By He, Haoran; Martinsson, Peter; Sutter, Matthias
  4. Selfconfirming Equilibrium and Uncertainty By Pierpaolo Battigalli; Simone Cerreia-Vioglio; Fabio Maccheroni; Massimo Marinacci
  5. Weitzman meets Nordhaus: Expected utility and catastrophic risk in a stochastic economy-climate model By Masako Ikefuji; Roger J. A. Laeven; Jan R. Magnus; Chris Muris
  6. Disentangling Motivational and Experiential Aspects of "Utility" - A Neuroeconomics Perspective By Ulrich Witt; Martin Binder
  7. Context and Decision: Utility on a Union of Mixture Spaces By O’Callaghan, Patrick
  8. Government bond risk premia and the cyclicality of fiscal policy By Kai Christoffel; Ivan Jaccard; Juha Kilponen
  9. Risk Aversion Heterogeneity, Risky Jobs and Wealth Inequality By Marco Cozzi
  10. Minimal Cost of a Brownian Risk without Ruin By Shangzhen Luo; Michael Taksar

  1. By: Olivier Chanel (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); 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
  2. 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 non-increasing and the optimal tax function is nondecreasing and concave.
    Keywords: Tax evasion; Income tax enforcement; Prospect theory
    JEL: D81 H26 K42
    Date: 2011–12
  3. 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 risk-taking of cohabitating student couples, finding that couples’ decisions are closer to risk-neutrality 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
  4. By: Pierpaolo Battigalli; Simone Cerreia-Vioglio; 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 "status-quo" 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
  5. By: Masako Ikefuji; Roger J. A. Laeven; Jan R. Magnus; Chris Muris
    Abstract: We specify a stochastic economy-climate model, adapting Nordhaus' deterministic economy-climate model by allowing for Weitzman-type stochasticity. We show that, under expected power utility, the model is fragile to heavy-tailed distributional assumptions and we derive necessary and sufficient conditions on the utility function to avoid fragility. We solve our stochastic economy-climate model for two cases with compatible pairs of utility functions and heavy-tailed 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
  6. By: Ulrich Witt; Martin Binder
    Abstract: Although decision makers are often reported to have difficulties in making comparisons between multi-dimensional decision outcomes, economic theory assumes a uni-dimensional 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
  7. By: O’Callaghan, Patrick (University of Warwick)
    Abstract: Suppose a decision-maker 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 decision-makers 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 state-dependence and comparability are distinct concepts. A final application provides a novel way modeling incomplete preferences and explaining the Allais paradox.
    Date: 2011
  8. By: Kai Christoffel (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Ivan Jaccard (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Juha Kilponen (Bank of Finland, Rauhankatu 19, FI-00101 Helsinki, Finland and European Financial Stability Facility.)
    Abstract: We introduce a specification of habit formation featuring non-separability 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 higher-order approximations. The model is able to reproduce a sizeable risk premium on long-term bonds and the cyclicality of fiscal policy has an impact on the bond premium that is quantitatively important. Technology, government spending, and mark-up shocks are the main drivers of the time-variation in bond premia. JEL Classification: E5, E6, G1.
    Keywords: DSGE models, fiscal policy, bond risk premium, monetary policy.
    Date: 2011–12
  9. 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 self-selection into risky jobs.
    Keywords: Wealth Inequality, Heterogeneous Agents, Incomplete Markets, Computable General Equilibrium
    JEL: E21 D52 D58 C68
    Date: 2011–12
  10. 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 excess-of-loss 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 non-negative, 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 quasi-variational inequalities (QVIs).
    Date: 2011–12

This nep-upt issue is ©2012 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.