nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2012‒05‒02
eleven papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Are small groups expected utility? By Morone, Andrea; Morone, Piergiuseppe
  2. A revealed preference test for weakly separable preferences By John K.-H. Quah
  3. Inference of Bidders’ Risk Attitudes in Ascending Auctions with Endogenous Entry, Second Version By Hanming Fang; Xun Tang
  4. Insurance demand under ambiguity and conflict for extreme risks : Evidence from a large representative survey. By Théodora Dupont-Courtade
  5. Foundations for Prospect Theory Through Probability Midpoint Consistency By Katarzyna Werner; Horst Zank
  6. The risk premium and long-run global imbalances By YiLi Chien; Kanda Naknoi
  7. Communication of uncertainty in weather forecasts By Marimo, Pricilla; Kaplan, Todd R; Mylne, Ken; Sharpe, Martin
  8. Model uncertainty, state uncertainty, and state-space models By Yulei Luo; Jun Nie; Eric R. Young
  9. The Precautionary Principle and chemical risks By Olivier Godard
  10. Alternative Modeling for Long Term Risk. By Dominique Guegan; Xin Zhao
  11. Risk Attitude in Couples By Philomena M. Bacon; Anna Conte; Peter G. Moffatt

  1. By: Morone, Andrea; Morone, Piergiuseppe
    Abstract: In this paper we analyse the empirical performance of several preference functionals using individual and group data. Our investigation aims to address two fundamental questions that have, until now, not been addressed in literature. Specifically, we intend to assess if there exists a risky choice theory that statistically fits group decisions significantly better than alternative theories, and if there are significant differences between individual and group choices. Experimental findings reported in this paper provide answers to both questions showing that when risky choices are undertaken by small groups (dyads in our case), disappointment aversion outperforms several alternative preference functionals, including expected utility. Since expected utility typically emerged as the dominant model in individual risky choices, this finding suggests that differences between individual and group choices exist, showing that the preference aggregation process drives out EU.
    Keywords: group decision; expected utility; risk and uncertainty
    JEL: D70 D81 C92 C91
    Date: 2012
  2. By: John K.-H. Quah
    Abstract: Consider a finite data set of price vectors and consumption bundles; under what conditions will there be a weakly separable utlity function that rationalizes the data? This paper shows that rationalization in this sense is possible if and only if there exists a preference order on some finite set of consumption bundles that is consistent with the observations and that is weakly separable. Since there can only be a finite number of preference orders on this set, the problem of rationalization with a weakly separable utility function is solvable.
    Keywords: Afriat's theorem, Concave utility function, Budget set, Generalized axiom of revealed preference, Preorder
    JEL: C14 C60 C61 D11 D12
    Date: 2012
  3. By: Hanming Fang (Department of Economics, University of Pennsylvania); Xun Tang (Department of Economics, University of Pennsylvania)
    Abstract: Bidders’ risk attitudes have important implications for sellers seeking to maximize expected revenues. In ascending auctions, auction theory predicts bid distributions in Bayesian Nash equilibrium does not convey any information about bidders' risk preference. We propose a new approach for inference of bidders’ risk attitudes when they make endogenous participation decisions. Our approach is based on the idea that bidders' risk premium - the difference between ex ante expected profits from entry and the certainty equivalent - required for entry into the auction is strictly positive if and only if bidders are risk averse. We show bidders' expected profits from entry into auctions is nonparametrically recoverable, if a researcher observes the distribution of transaction prices, bidders' entry decisions and some noisy measures of entry costs. We propose a nonparametric test which attains the correct level asymptotically under the null of risk-neutrality, and is consistent under fixed alternatives. We provide Monte Carlo evidence of the finite sample performance of the test. We also establish identification of risk attitudes in more general auction models, where in the entry stage bidders receive signals that are correlated with private values to be drawn in the bidding stage.
    Keywords: Ascending auctions, Risk attitudes, Endogenous entry, Nonparametric Test, Bootstrap
    JEL: D44 C12 C14
    Date: 2011–05–28
  4. By: Théodora Dupont-Courtade (Centre d'Economie de la Sorbonne - Paris School of Economics)
    Abstract: This paper investigates how the general public behaves when confronted with low probability events and ambiguity in an insurance context. It reports the results of a questionnaire completed by a large representative sample of the French population that aims at separating attitudes toward risk, imprecision and conflict and at determining if there is a demand for ambiguous and extreme event risks. The data show a strong distinction between two aspects of the problem : the decision of purchasing insurance and the willingness to pay. In the decision to insure, more than 25% of the respondents refuse to buy insurance and people are more willing to insure in a risky situation than in an ambiguous one. This certain taste for risk can be explained by the respondents' observable characteristics. In addition, it highlights a lack of confidence in the insurance markets. When it comes to willingness to pay, people exhibit ambiguity seeking behaviors. They are willing to pay more under risk than under ambiguity (embracing here imprecision and conflict), revealing that people consider ambiguous situations as inferior. Furthermore, respondents behave differently under imprecision and conflict. They exhibit a preference for consensual information and dislike conflicts. However, the willingness to pay is poorly correlated with observable characteristics.
    Keywords: Ambiguity, imprecision, conflict, decision making, extreme risk, insurance demand, willingness to pay.
    JEL: C93 D81 D83 Q54
    Date: 2012–01
  5. By: Katarzyna Werner; Horst Zank
    Date: 2012
  6. By: YiLi Chien; Kanda Naknoi
    Abstract: Our paper investigates whether the valuation effect caused by a large risk premium and a low risk-free rate can help to explain the enormous US current account and trade deficit observed in the past decade. To answer this question, we set up an endowment growth model in which investors are endowed with heterogeneous trading technologies. In our model, the average US investors load up more aggregate risk by investing in a risky asset abroad and issuing a risk-free asset. Thanks to the large risk premium as well as the low risk-free rate, the US can sustain a long-run trade deficit even as a debtor country. Quantitatively, we find that the valuation effect caused solely by the high risk premium and the low risk-free rate in our model, which is calibrated to match the external assets and liabilities of the US economy, can account for more than half of the observed trade deficit and current account deficit. Our results suggest that the current US trade deficit might not necessarily lead to net export increases or dollar depreciation in the future.
    Keywords: International trade ; Risk management
    Date: 2012
  7. By: Marimo, Pricilla; Kaplan, Todd R; Mylne, Ken; Sharpe, Martin
    Abstract: Experimental economics methods were used to assess public understanding of information in weather forecasts and test whether the participants were able to make better decisions using the probabilistic information presented in table or bar graph formats than if they are presented with a deterministic forecast. We asked undergraduate students from the University of Exeter to choose the most probable temperature outcome between a set of “lotteries” based on the temperature up to five days ahead. If they choose a true statement, participants were rewarded with a cash reward. Results indicate that on average participants provided with uncertainty information make better decisions than those without. Statistical analysis indicates a possible learning effect as the experiment progressed. Furthermore, participants who were shown the graph with uncertainty information took on average less response time compared to those who were shown a table with uncertainty information.
    Keywords: experimental economics; uncertainty; decision making; bar graph; table
    JEL: D81 D83 C91
    Date: 2012
  8. By: Yulei Luo; Jun Nie; Eric R. Young
    Abstract: This technical paper considers ways to capture uncertainty in the context of so-called "state-space" models. ; State-space models are powerful tools commonly used in macroeconomics, international economics, and finance. State-space models can generate estimates of an underlying, ultimately unobserved variable—such as the natural rate of unemployment—based on the movements of other variables that are observed and have some relationship to the unobserved variable. The paper shows how several macroeconomic models can be mapped to the state-space framework, thus helping quantify uncertainty about the true model (model uncertainty) or about the amount of information available when decisions are made (state uncertainty).
    Date: 2012
  9. By: Olivier Godard (Department of Economics, Ecole Polytechnique - CNRS : UMR7176 - Polytechnique - X)
    Abstract: EU institutions (Commission, Council and Parliament) have adopted the EU doctrine of the Precautionary Principle (PP) in year 2000, whereas the EU is the sole huge region where something called the PP is implemented and controlled by case law. There is nevertheless a huge contrast between this doctrine and other views put forward by stakeholders, specially NGOs, and academic circles. For instance the PP is often confused with a Maximin approach or catastrophism, which are shown to be inconstant standards under uncertainty. Against this background, the links between the PP and the REACH regulation for chemical products are questioned. Beyond common features, it is shown that these normative constructs are no substitutes and that the PP should go on to inspire public action for chemical substances in conjunction with REACH.
    Keywords: Precautionary principle, Europe, risk management, chemicals, REACH
    Date: 2012–04–20
  10. By: Dominique Guegan (Centre d'Economie de la Sorbonne - Paris School of Economics); Xin Zhao (Centre d'Economie de la Sorbonne)
    Abstract: In this paper, we propose an alternative approach to estimate long-term risk. Instead of using the static square root method, we use a dynamic approach based on volatility forecasting by non-linear models. We explore the possibility of improving the estimations by different models and distributions. By comparing the estimations of two risk measures, value at risk and expected shortfall, with different models and innovations at short, median and long-term horizon, we find out that the best model varies with the forecasting horizon and the generalized Pareto distribution gives the most conservative estimations with all the models at all the horizons. The empirical results show that the square root method underestimates risk at long horizon and our approach is more competitive for risk estimation at long term.
    Keywords: Long memory, Value at Risk, expect shortfall, extreme value distribution.
    JEL: G32 G17 C58
    Date: 2012–03
  11. By: Philomena M. Bacon (Department of Economics, Lancaster University Management School, United Kingdom); Anna Conte (Strategic Interaction Group, Max Planck Institute of Economics, Jena, and EQM Department, University of Westminster, London); Peter G. Moffatt (School of Economics, University of East Anglia, Norwich, United Kingdom)
    Abstract: The determinants of risk attitude in couples are explored using data from the German Socio-Economic Panel over the period 2004 to 2009. The focus of the analysis is the repeated responses to the survey question about general willingness to take risk. Responses to this question are provided on a 0-10 Likert scale. We focus on couples in the data set, and we apply the bivariate panel ordered probit model to the analysis of the simultaneous determination of the male's and the female's risk attitude. A number of individual characteristics, including age, height, education and household income, are found to have strong effects on risk attitude, in some cases differing markedly between the male and the female. Both the individual-specific effects and the observation-specific error terms are assumed to have non-zero correlations between the two equations. These correlations are estimated to be +0.27 and +0.28 respectively. We consider the former to be a key parameter, since its positive sign may be interpreted as a form of homophily: individuals tend to form partnerships with others having a similar risk attitude.
    Keywords: Multiple Equation Models, Panel Data, Risk Attitude
    JEL: C33 D81
    Date: 2012–04–25

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