nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2012‒06‒05
eleven papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Recursive Ambiguity and Machina's Examples By David Dillenberger; Uzi Segal
  2. Value and utility in a historical perspective By Pogany, Peter
  3. On the stability of the CRRA utility under high degrees of uncertainty By T M Niguez; Ivan Paya; D Peel; J Perote
  4. Ambiguous Business Cycles By Cosmin Ilut; Martin Schneider
  5. Stability of the exponential utility maximization problem with respect to preferences By Hao Xing
  6. Rationalizing Choice with Multi-Self Models By Attila Ambrus; Kareen Rozen
  7. Measuring risk aversion with lists: A new bias By Antoni Bosch-Domènech; Joaquim Silvestre
  8. The Anatomy of Error in Decision-making of Rationally Behaving Agents from the Perspective of the Theory of Bounded Rationality: Extension for Contextual Games By Tomas Otahal; Radim Valencik
  9. Aging and Attitudes Towards Strategic Uncertainty and Competition: An Artefactual Field Experiment in a Swiss Bank By Thierry Madiès; Marie-Claire Villeval; Malgorzata Wasmer
  10. Life Insurance Purchasing to Maximize Utility of Household Consumption By Erhan Bayraktar; Virginia R. Young
  11. Non-rational expectations and the transmission mechanism By Harrison, Richard; Taylor, Tim

  1. By: David Dillenberger (University of Pennsylvania); Uzi Segal (Boston College)
    Abstract: Machina (2009, 2012) lists a number of situations where standard models of ambiguity aversion are unable to capture plausible features of ambiguity attitudes. Most of these problems arise in choice over prospects involving three or more outcomes. We show that the recursive non-expected utility model of Segal (1987) is rich enough to accommodate all these situations.
    Keywords: tAmbiguity, Ellsberg paradox, Choquet expected utility, recursive non-expected utility
    JEL: D81
    Date: 2012–05–20
  2. By: Pogany, Peter
    Abstract: Since value and utility are the highest profile abstractions that underlie an epoch’s intellectual climate and ethical principles, their evolution reflects the transformation of socioeconomic conditions and institutions. The “Classical Phase” flourished during the first global system, laissez-faire/metal money/zero multilateralism (GS1); the second, “Subjective/Utilitarian” phase marked the long transition to the current epoch of “Modern Subjectivism/General Equilibrium,” tied to the second and extant global system, mixed economy/minimum reserve banking/weak multilateralism (GS2). History has witnessed the material de-essentialization of value and substantialization of utility. But now the two concepts face a thorough transvaluation as the world’s combined demographic and economic expansion encounters ecological/physical limitations. An extended macrohistoric implosion may lead to a third form of global self-organization: two-level economy/maximum bank reserve money/strong multilateralism (GS3). If history unfolds along the suggested path, not only economics, but also thinking about economics would change. It would be considered an evolving hermeneutic of the human condition expressed through global-system-specific texts. The implied critical alteration, with the recognition of the entropy law’s importance as its focal point, matches the prediction of Swiss thinker Jean Gebser (1905-1973) about the impending mutation of human consciousness into its integral/arational structure. Such extrapolations form the context in which the fourth historical phase of value and utility is hypothesized, leading to the material re-essentialization of value and de-substantialization of utility.
    Keywords: value; utility; new historical materialism; a new take on universal history
    JEL: A12 Z10 N00 Q01 B00
    Date: 2012–05–15
  3. By: T M Niguez; Ivan Paya; D Peel; J Perote
    Abstract: Economic growth models under uncertainty and rational agents with CRRA utility have been shown to provide quite fragile explanations of consumers.choice as equlib- rium comsumption paths (expected utility) are drastically dependant on distributional assumptions. We show that assuming a SNP distribution for random consumption provides stability to general equilibrium models as expected utility exists for any value of the marginal rate of substitution over time.
    Date: 2011
  4. By: Cosmin Ilut; Martin Schneider
    Abstract: This paper considers business cycle models with agents who dislike both risk and ambiguity (Knightian uncertainty). Ambiguity aversion is described by recursive multiple priors preferences that capture agents' lack of confidence in probability assessments. While modeling changes in risk typically requires higher-order approximations, changes in ambiguity in our models work like changes in conditional means. Our models thus allow for uncertainty shocks but can still be solved and estimated using first-order approximations. In our estimated medium-scale DSGE model, a loss of confidence about productivity works like `unrealized' bad news. Time-varying confidence emerges as a major source of business cycle fluctuations.
    Date: 2012
  5. By: Hao Xing
    Abstract: This paper studies stability of the exponential utility maximization when there are small variations on agent's utility. Two settings are studied. First, in a general semimartingale model where random endowments are present, there is a sequence of utilities defined on R converging to the exponential utility. Under a uniform condition on their marginal utilities, convergence of value functions, optimal terminal wealth and optimal investment strategies are obtained, their rate of convergence are determined. Stability of utility-based pricing is also discussed. Second, there is a sequence of utilities defined on R_+ each of which is comparable to a power utility whose relative risk aversion converges to infinity. Their associated optimal strategies, after appropriate scaling, converge to the optimal strategy for the exponential hedging problem. This complements Theorem 3.2 in \textit{M. Nutz, Probab. Theory Relat. Fields, 152, 2012}, by allowing general utilities in the converging sequence.
    Date: 2012–05
  6. By: Attila Ambrus; Kareen Rozen
    Abstract: This paper studies a class of multi-self decision-making models proposed in economics, psychology, and marketing. In this class, choices arise from the set-dependent aggregation of a collection of utility functions, where the aggregation procedure satisfies some simple properties. We propose a method for characterizing the extent of irrationality in a choice behavior, and use this measure to provide a lower bound on the set of choice behaviors that can be rationalized with n utility functions. Under an additional assumption (scale-invariance), we show that generically at most five "reasons" are needed for every "mistake."
    Keywords: Multi-self models, index of irrationality, IIA violations, rationalizability
    JEL: D11 D13 D71
    Date: 2012
  7. By: Antoni Bosch-Domènech; Joaquim Silvestre (Department of Economics, University of California Davis)
    Abstract: Various experimental procedures aimed at measuring individual risk aversion involve a list of pairs of alternative prospects. We first study the widely used method by Holt and Laury (2002), for which we find that the removal of some items from the lists yields a systematic decrease in risk aversion. This bias is quite distinct from other confounds that have been previously observed in the use of the Holt and Laury method. It may be related to empirical phenomena and theoretical developments where better prospects increase risk aversion. Nevertheless, we have also found that the more recent elicitation method due to Abdellaoui et al. (2011), also based on lists, does not display any statistically significant bias when the corresponding items of the list are removed. Our results suggest that methods other than the popular Holt and Laury one may be preferable for the measurement of risk aversion.
    Keywords: Risk aversion, risk attitudes, experiments, lists, elicitation method, Holt, Laury, Abdellaoui, Driouchi, l’Haridon, independence axiom
    JEL: C
    Date: 2012–05–20
  8. By: Tomas Otahal (Department of Economics, Faculty of Business and Economics, Mendel University in Brno); Radim Valencik (University of Finance and Administration)
    Abstract: How can errors in decision-making by rationally behaving individuals be explained? The concepts of bounded rationality proposed by H. Simon and of imperfect information in the complex reality by F. Hayek attack the over-restrictive assumption of perfectly informed individuals or organisms in neoclassical microeconomics. Since this assumption excludes erroneous decision-making, some results must be explained by questioning the rationality assumption. In this paper, we show that erroneous decision-making of individuals and organisms is not necessarily erroneous if we look at the contextual games which individuals and organisms play in the complex reality. This helps to explain errors in the decision-making of individuals or organisms, while maintaining the assumption of rational behavior. At the same time, we show that the errors observed in the contextual analysis of games in the decision-making of individuals or organisms can only be apparent.
    Keywords: Bounded rationality, complex systems, contextual games, erroneous behavior, rational decision-making
    JEL: D01 C73
    Date: 2012–06
  9. By: Thierry Madiès (University of Fribourg, Bd de Pérolles 90, CH-1700 Fribourg, Switzerland); Marie-Claire Villeval (Université de Lyon, Lyon, F-69007, France ; CNRS, GATE Lyon St Etienne,F-69130 Ecully, France); Malgorzata Wasmer (University of Fribourg, Bd de Pérolles 90, CH-1700 Fribourg, Switzerland)
    Abstract: We study the attitudes of junior and senior employees towards strategic uncertainty and competition, by means of a market entry game inspired by Camerer and Lovallo (1999). Seniors exhibit higher entry rates compared to juniors, especially when earnings depend on relative performance. This difference persists after controlling for attitudes towards non-strategic uncertainty and for beliefs on others’ competitiveness and ability. Social image matters, as evidenced by the fact that seniors enter more when they predict others enter more and when they are matched with a majority of juniors. This contradicts the stereotype of risk averse and less competitive older employees.
    Keywords: Aging, risk, ambiguity, competitiveness, self-image, confidence, experiment
    JEL: C91 D83 J14 J24 M5
    Date: 2012
  10. By: Erhan Bayraktar; Virginia R. Young
    Abstract: We determine the optimal amount of life insurance for a household of two wage earners. We consider the simple case of exponential utility, thereby removing wealth as a factor in buying life insurance, while retaining the relationship among life insurance, income, and the probability of dying and thus losing that income. For insurance purchased via a single premium or premium payable continuously, we explicitly determine the optimal death benefit. We show that if the premium is determined to target a specific probability of loss per policy, then the rates of consumption are identical under single premium or continuously payable premium. Thus, not only is equivalence of consumption achieved for the households under the two premium schemes, it is also obtained for the insurance company in the sense of equivalence of loss probabilities.
    Date: 2012–05
  11. By: Harrison, Richard (Bank of England); Taylor, Tim (Bank of England)
    Abstract: In this paper, we compare two approaches to modelling behaviour under non-rational expectations in a benchmark New Keynesian model. The ‘Euler equation’ approach modifies the equations derived under the assumption of rational expectations by replacing the rational expectations operator with an alternative assumption about expectations formation. The ‘long-horizon’ expectations approach solves the decision rules of households and firms conditional on their expectations for future events that are outside of their control, so that spending and price-setting decisions depend on expectations extending into the distant future. Both approaches can be defended as descriptions of (distinct) forms of boundedly rational behaviour, but have different implications both for the form of the equations that govern the dynamics of the economy and the ease of deriving those equations. In this paper we construct two versions of a benchmark New Keynesian model in which non-rational expectations are modelled using the Euler equation and long-horizon approaches and show that both approaches have very similar implications for macroeconomic dynamics when departures from rational expectations are relatively small. But as expectations depart further from rationality, the two approaches can generate significantly different implications for the behaviour of key variables.
    Keywords: Expectations; monetary transmission mechanism
    JEL: D84 E17
    Date: 2012–05–18

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