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on Utility Models and Prospect Theory |
| By: | Thierry Chauveau (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon Sorbonne) |
| Abstract: | If an investor does care for utilities -and not for monetary outcomes- stochastic dominances should be expresed in terms of utility units ("utils"). If so, any "rational" investor may be characterized by an elementary function u(.) which is such that the random variables u (w) -where w is a random prospect- never violate the second-order stochastic dominance property and that the partial weak order induced by stochastic dominance over utils is as "close" to the weak order of preferences as possible. Similarly "subjective" risk must be substituted for "objective" risk à la Rothschild and Stiglitz (1970). A weakened independence axiom may then be set over comparable prospects, i.e. those which exhibit the same expected utility. This leads to a fully choice-based theory of disappointment. The functional is lottery-dependent (Becker and Sarin 1987). When constant marginal utility is assumed, it is but the opposite to a convex measure of risk (Föllmer and Shied 2002). It may be viewed as a theoretical justification for choosing this measure of risk. |
| Keywords: | Disappointment; risk-aversion; subjective risk; risk premium; expected utility. |
| Date: | 2012–10 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-00747902&r=upt |
| By: | Marco Castillo; David L. Dickinson; Ragan Petrie |
| Abstract: | We investigate the consistency and stability of individual risk preferences by slightly manipulating the cognitive resources of subjects through sleepiness. Participants are recruited and randomly assigned to an experiment session at a preferred time of day relative to their diurnal preference (circadian matched) or at a non-preferred time of day (circadian mismatched). For the decision task, subjects and are asked to choose how much to allocate between two state-dependent assets (using the Choi et al., 2007, design). We have two main findings. First, the consistency of behavior for circadian matched and mismatched subjects is statistically the same. This is true whether it is (nonparametrically) defined as consistency with GARP, payoff dominance, expected utility, disappointment aversion or cumulative prospect theory. Second, while our cognitive resource manipulation yields no difference in consistency of behavior, it results in an increased tendency to take risk. Our experiment confirms theoretical predictions that preferences are consistent yet state-dependent. Key Words: |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:apl:wpaper:12-04&r=upt |
| By: | Nicolas Drouhin (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon Sorbonne, ENS Cachan - Ecole Normale Supérieure de Cachan - École normale supérieure de Cachan - ENS Cachan) |
| Abstract: | In a continuous time life cycle model of consumption with uncertain lifetime and no ''pure time preference", we use a non-parametric specification of rank dependent utility theory to characterize the preferences of the agents. From normative point of view, the paper discusses the implication of adding an axiom of time consistency to the former model. We prove that time consistency holds for a much wider class of probability weighting functions than the identity one characterizing the expected utility model. This special class of probability weighting functions provides foundations for a constant subjective rate of discount which interact multiplicatively with the instantaneous conditional probability of dying. We show that even if agent are time consistent, life annuities no more provide perfect insurance against the risk to live. |
| Keywords: | intertemporal choice; life cycle theory of consumption and saving; uncertain lifetime; life insurance; time consistency; rank dependent utility. |
| Date: | 2012–10–31 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-00748662&r=upt |
| By: | Martín Egozcue (Universidad de la República - Facultad de Ciencias Sociales); Sébastien Massoni (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon Sorbonne); Wing-Keung Wong (Hong Kong Baptist University - Department of Economics and the Institute for Computational Mathematics); Ričardas Zitikis (University of Western Ontario - Department of Statistical and Actuarial Sciences) |
| Abstract: | Whether to keep products segregated (e.g., unbundled) or integrate some or all of them (e.g., bundle) has been a problem of profound interest in areas such as portfolio theory in finance, risk capital allocations in insurance, and marketing of consumer products. Such decisions are inherently complex and depend on factors such as the underlying product values and consumer preferences, the latter being frequently described using value functions, also known as utility functions in economics. In this paper, we develop decision rules for multiple products, which we generally call 'exposure units' to naturally cover manifold scenarios spanning well beyond 'products'. Our findings show, for example, that the celebrated Thaler's principles of mental accounting hold as originally postulated when the values of all exposure units are positive (i.e., all are gains) or all negative (i.e., all are losses). In the case of exposure units mixed-sign values, decision rules are much more complex and rely on cataloging the Bell-number of cases that grow very fast depending on the number of exposure units. Consequently, in the present paper we provide detailed rules for the integration and segregation decisions in the case up to three exposure units, and partial rules for the arbitrary number of units. |
| Keywords: | Bundling; marketing; mental accounting; portfolio theory; value fonction; utility function; majorization; functional inequalities; Bell number. |
| Date: | 2012–09 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-00747008&r=upt |
| By: | Yu-Fu Chen; Dennis Petrie |
| Abstract: | This paper models the decision to quit smoking like an investment decision where the quitter incurs a sunk withdrawal cost today and forgoes their consumer surplus from cigarettes (invests) and hopes to reap an uncertain reward of better health and therefore higher utility in the future (return). We show that a risk-averse mature smoker who expects to benefit from quitting may still rationally choose to delay quitting until they are more confident that quitting is the right decision for them. Such a decision by the smoker is due to the value associated with keeping their option of whether or not to quit open as they learn more about the damage that smoking will have on their future utility. Policies which reduce a smoker’s uncertainty about the damage that smoking with have on their future utility is likely to make them quit earlier. |
| Keywords: | smoking, quitting, optimal stopping problem, real options analysis, addiction |
| JEL: | I1 D1 D8 D9 |
| Date: | 2012–11 |
| URL: | http://d.repec.org/n?u=RePEc:dun:dpaper:272&r=upt |
| By: | Demian Pouzo; Ignacio Presno |
| Abstract: | This paper studies how foreign investors' concerns about model misspecification affect sovereign bond spreads. We develop a general equilibrium model of sovereign debt with endogenous default wherein investors fear that the probability model of the underlying state of the borrowing economy is misspecified. Consequently, investors demand higher returns on their bond holdings to compensate for the default risk in the context of uncertainty. In contrast with the existing literature on sovereign default, we explain the bond spreads dynamics observed in the data as well as other business cycle features for Argentina, while preserving the default frequency at historical low levels. |
| Keywords: | Bonds ; Debts, External |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedbwp:12-11&r=upt |
| By: | Daniel Laskar (EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris, PSE - Paris-Jourdan Sciences Economiques - CNRS : UMR8545 - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - Ecole des Ponts ParisTech - Ecole Normale Supérieure de Paris - ENS Paris - INRA) |
| Abstract: | We consider a two-player global game where creditors, who finance some investment project, have to decide whether to roll over their loans or not. We use a non-Bayesian approach where creditors exhibit some aversion to ambiguity. We show that an increase in ambiguity reduces the perceived coordination of players in rolling over their loans. This contibutes to increasing the probability of a financial crisis, and therefore provides an additional argument in favor of transparency in the model considered. |
| Keywords: | Financial crises ; Ambiguity ; Uncertainty ; Global games ; Coordination ; Transparency |
| Date: | 2012–11 |
| URL: | http://d.repec.org/n?u=RePEc:hal:psewpa:halshs-00749500&r=upt |
| By: | Michele Berardi; Jaqueson K. Galimberti |
| Abstract: | The literature on bounded rationality and learning in macroeconomics has often used recursive algorithms such as least squares and stochastic gradient to depict the evolution of agents' beliefs over time. In this work, we try to assess the plausibility of such practice from an empirical perspective, by comparing forecasts obtained from these algorithms with survey data. In particular, we show that the relative performance of the two algorithms in terms of forecast errors depends on the variable being forecasted, and we argue that rational agents would therefore use different algorithms when forecasting different variables. By using survey data, then, we show that agents instead always behave as least squares learners, irrespective of the variable being forecasted. We thus conclude that such findings point to a puzzling conflict between rational and actual behaviour when it comes to expectations formation. |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:man:cgbcrp:177&r=upt |
| By: | Nagayasu, Jun |
| Abstract: | This paper re-evaluates the forward premium puzzle using the Euro/US dollar exchange rate. Unlike previous studies, a state-space model is used to measure the significance of this puzzle by estimating the time-specific parameter. Then we provide evidence that the forward premium puzzle became more prominent around the time of the Lehman Shock, and this additional effect of the puzzle is more clearly seen in longer maturity assets. Furthermore, while the risk premium does not tell the whole story about the time-varying puzzle, we show nevertheless that the puzzle can be lessened by this extra factor particularly at times of financial crises. |
| Keywords: | forward premium puzzle; risk premium; time-varying parameters; financial crises |
| JEL: | F3 |
| Date: | 2012–09–01 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:42472&r=upt |
| By: | Patricia Apps; Yuri Andrienko; Ray Rees |
| Abstract: | The existing literature suggests that when the saving decision of two-earner households under risk is analysed, standard results on the existence of precautionary saving no longer apply: precautionary saving is obtained if and only if very stringent conditions hold. This paper shows that when the two-earner households saving decision is formulated more generally, standard assumptions suffice for precautionary saving to exist under increases in risk of the first and second orders, but not for higher orders. |
| Keywords: | Two-earner households, risk order, precautionary saving |
| JEL: | D10 D13 D14 D81 D91 E21 |
| Date: | 2012–11 |
| URL: | http://d.repec.org/n?u=RePEc:auu:dpaper:674&r=upt |
| By: | Steffen Ahrens |
| Abstract: | In this paper we incorporate the two most prominent approaches of inequality aversion, i.e. Fehr and Schmidt (1999) and Bolton and Ockenfels (2000) into an otherwise standard New Keynesian macro model and compare them with respect to their influence on the long-run effectiveness of monetary policy. We find that the choice for Fehr and Schmidt or Bolton and Ockenfels like preferences is of importance only for the quantitative - but not the qualitative - effectiveness of monetary policy in the long-run |
| Keywords: | price stickiness, long-run Phillips curve, inequality aversion |
| JEL: | D03 E20 E31 E50 |
| Date: | 2012–11 |
| URL: | http://d.repec.org/n?u=RePEc:kie:kieliw:1802&r=upt |
| By: | Nævdal, Erik (The Frisch Centre for EConomic Research); Vislie, Jon (Dept. of Economics, University of Oslo) |
| Abstract: | An intertemporal optimal strategy for accumulation of reversible capital and management of an exhaustible resource is analyzed for a global economy when resource depletion generates discharges that add to a stock pollutant that affects the likelihood for hitting a tipping point or threshold of unknown location, causing a random“disembodied technical regress”. We characterize the optimal strategy by imposing the notion “precautionary tax” on current extraction. Such a tax will internalize future expected damages or expected welfare loss should a threshold be hit. With reversible capital the presence of a stochastic threshold should speed up accumulation as long as no threshold is hit so as to build up a buffer or stock for future consumption should a threshold be hit. |
| Keywords: | Catastrophic risk and stochastic thresholds; capital accumulation; precautionary taxation; stock pollution; resource extraction |
| JEL: | C61 Q51 Q54 |
| Date: | 2012–09–07 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:osloec:2012_024&r=upt |
| By: | Jérôme Hergueux (LaRGE - Laboratoire de Recherche en Gestion et Economie, Sciences Po - Sciences Po); Nicolas Jacquemet (EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris, BETA - Bureau d'économie théorique et appliquée - CNRS : UMR7522 - Université de Strasbourg - Université Nancy II, CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon Sorbonne) |
| Abstract: | Internet is a very attractive technology for experiments implementation, both in order to reach more diverse and larger samples and as a field of economic research in its own right. This paper reports on an experiment performed both online and in the laboratory, designed so as to strengthen the internal validity of decisions elicited over the Internet. We use the same subject pool, the same monetary stakes and the same decision interface, and randomly assign two group of subjects between the Internet and a traditional University laboratory to compare behavior in a set of social preferences games. This comparison concludes in favor of the reliability of behaviors elicited through the Internet. Our behavioral results contradict the predictions of social distance theory, as we find that subjects allocated to the Internet treatment behave as if they were more altruistic, more trusting, more trustworthy and less risk averse than laboratory subjects. Those findings have practical importance for the growing community of researchers interested in using the Internet as a vehicle for social experiments and bear interesting methodological lessons for social scientists interested in using experiments to research the Internet as a field. |
| Keywords: | Social experiment, field experiment, internet, methodology, randomized assignment. |
| Date: | 2012–10 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-00748615&r=upt |
| By: | Elie Appelbaum (Department of Economics, York University, Toronto, Canada); Mark Melatos |
| Abstract: | This paper analyzes how uncertainty and the timing of its resolution infuence the formation and design of regional trade agreements. Two sources of uncertainty — in demand and costs — are considered. We compare the case in which uncertainty is resolved “early” (before tariffs are chosen), with the case in which uncertainty is resolved “late” (after tariffs are chosen). These cases are, in turn, compared with the benchmark case of no uncertainty. We demonstrate that, as long as some decisions are made after uncertainty is resolved, trade agreements have option values. These option values differ across agreements, reFecting members’ different degrees of (trade policy) freedom to respond to changes in the trading environment. Moreover, these option values may be sufficiently large as to lead prospective members to opt for a more Fexible trading arrangement(such as a free trade area) over a less Fexible agreement (such as a customs union). Indeed, countries may even prefer to stand alone than join a free trade area under some circumstances. Finally, we show that the timing of the resolution of uncertainty can signiFcantly impact the type of trade agreement that countries wish to form. |
| Keywords: | Trade Agreement, Free Trade Area, Customs Union, Uncertainty, Resolution of Uncertainty |
| JEL: | F12 F13 F15 D81 |
| Date: | 2012–04–17 |
| URL: | http://d.repec.org/n?u=RePEc:yca:wpaper:2012_1&r=upt |