nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2013‒02‒16
twelve papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Prospect theory in the health domain: a quantitative assessment By Attema, Arthur; Brouwer, Werner; l'Haridon, Olivier
  2. Manipulating Reliance on Intuition Reduces Risk and Ambiguity Aversion By Jeffrey V. Butler; Luigi Guiso; Tullio Jappelli
  3. Loss Aversion and Seller Behavior : Evidence from the Housing Market : Comment Working Paper. By Florent Buisson
  4. Overbidding and Heterogeneous Behavior in Contest Experiments By Roman M. Sheremeta
  5. Polarization and Ambiguity By Sandeep Baliga; Eran Hanany; Peter Klibanoff
  6. Relative risk aversion and power-law distribution of macroeconomic disasters By Michał Brzeziński
  7. Representing Aggregate Belief through the Competitive Equilibrium of a Securities Market By David M. Pennock; Michael P. Wellman
  8. Characterizing Behavioral Decisions with Choice Data By Ghosal, Sayantan; Dalton, Patricio
  9. Basis of financial arithmetic from the viewpoint of the utility theory By Krzysztof Piasecki
  10. The Role of Bounded Rationality in Macro-Finance Affine Term-Structure Models By Yun, Tack; Kim, Jinsook; Ko, Eunmi
  11. Fresh Vegetable Growers' Risk Perception, Risk Preference and Choice of Marketing Contracts: A Choice Experiment By Vassalos, Michael; Hu, Wuyang; Woods, Timothy A.; Schieffer, Jack; Dillon, Carl R.
  12. Small Area Estimation of Insurance Premiums and Basis Risk By Awondo, Sebastain N.; Datta, Gauri S.; Ramirez, Octavio A.; Fonsah, Esendugue Greg

  1. By: Attema, Arthur; Brouwer, Werner; l'Haridon, Olivier
    Abstract: It is well-known that expected utility (EU) has empirical deficiencies. Prospect theory (PT) has developed as an alternative with more descriptive validity. However, PT’s full function had not yet been quantified in the health domain. This paper is the first to simultaneously measure utility of life duration, probability weighting, and loss aversion for health. We observe loss aversion and risk aversion, which for gains can be explained by probabilistic pessimism. Utility for gains is almost linear. For losses, we find less weighting of probability 1/2 and concave utility. This contrasts with the common finding of convex utility for monetary losses. However, PT was proposed to explain choices among lotteries involving small outcomes. Life years are arguably not ‘small’ and need not generate convex utility for losses. Moreover, utility of life duration reflects discounting, causing concave utility. These results are a first step in fitting non-EU models for health-related decisions.
    Keywords: Loss aversion; Prospect theory; QALY model; Utility of life duration
    JEL: B41 I10
    Date: 2013–01–31
  2. By: Jeffrey V. Butler (Einaudi Institute for Economics and Finance (EIEF)); Luigi Guiso (Einaudi Institute for Economics and Finance (EIEF)); Tullio Jappelli (University of Naples Federico II and CSEF)
    Abstract: Prior research suggests that those who rely on intuition rather than effortful reasoning when making decisions are less averse to risk and ambiguity. The evidence is largely correlational, however, leaving open the question of the direction of causality. In this paper, we present experimental evidence of causation running from reliance on intuition to risk and ambiguity preferences. We directly manipulate participants’ predilection to rely on intuition and find that enhancing reliance on intuition lowers the probability of being ambiguity averse by 30 percentage points and increases risk tolerance by about 30 percent in the experimental sub-population where we would a priori expect the manipulation to be successful (males)
    Keywords: Risk Aversion, Risk Ambiguity, Decision Theory, Dual Systems, Intuitive Thinking
    JEL: D81 D83
    Date: 2013–01–24
  3. By: Florent Buisson (Centre d'Economie de la Sorbonne - Paris School of Economics)
    Abstract: In an often quoted article, Genesove and Mayer (2001) observe that house sellers are reluctant to sell at a loss, and attribute this finding to loss aversion. I show that loss aversion cannot explain this phenomenon.
    Keywords: Loss aversion, prospect theory, housing market.
    JEL: D03 D11 D83
    Date: 2013–01
  4. By: Roman M. Sheremeta (Argyros School of Business and Economics, Chapman University)
    Abstract: We provide an overview of experimental literature on contests and point out the two main phenomena observed in most contest experiments- (i) overbidding relative to the standard Nash equilibrium prediction and (ii) heterogeneous behavior of ex-ante symmetric contestants. Based on the sample of contest experiments that we review, the median overbidding rate is 72%. We provide different explanations for the overbidding phenomenon, including bounded rationality, utility of winning, other-regarding preferences, probability distortion, and the shape of the payoff function. We also provide explanations for heterogeneous behavior of contestants based on differences in preferences towards winning, inequality, risk and losses, and demographic differences. Furthermore, we suggest mechanisms that can reduce overbidding and induce more homogeneous behavior. Finally, we discuss directions for future research.
    Keywords: experiments, contests, overbidding, heterogeneous behavior
    JEL: C72 C91 C92 D72 D74
    Date: 2013
  5. By: Sandeep Baliga; Eran Hanany; Peter Klibanoff
    Abstract: We offer a theory of polarization as an optimal response to ambiguity. Suppose individual A's beliefs first-order stochastically dominate individual B's. They observe a common signal. They exhibit polarization if A's posterior dominates her prior and B's prior dominates her posterior. Given agreement on conditional signal likelihoods, we show that polarization is impossible under Bayesian updating or after observing extreme signals. However, we also show that polarization can arise after intermediate signals as ambiguity averse individuals implement their optimal prediction strategies. We explore when this polarization will occur and the logic underlying it.
    Keywords: Ambiguity aversion, Ellsberg, beliefs, updating, dynamic consistency
    Date: 2013–01–10
  6. By: Michał Brzeziński (Faculty of Economic Sciences, University of Warsaw)
    Abstract: The coefficient of relative risk aversion (CRRA) is notoriously difficult to estimate. Recently, Barro and Jin (On the size distribution of macroeconomic disasters, Econometrica 2011; 79(3): 434–455) have come up with a new estimation approach that fits a power-law model to the tail of distribution of macroeconomic disasters. We show that their results can be successfully replicated using a more refined power-law fitting methodology and a more comprehensive data set.
    Keywords: coefficient of relative risk aversion, power-law modelling, macroeconomic disasters, replication, robust statistics
    JEL: D81 E32 C46
    Date: 2013
  7. By: David M. Pennock; Michael P. Wellman
    Abstract: We consider the problem of belief aggregation: given a group of individual agents with probabilistic beliefs over a set of uncertain events, formulate a sensible consensus or aggregate probability distribution over these events. Researchers have proposed many aggregation methods, although on the question of which is best the general consensus is that there is no consensus. We develop a market-based approach to this problem, where agents bet on uncertain events by buying or selling securities contingent on their outcomes. Each agent acts in the market so as to maximize expected utility at given securities prices, limited in its activity only by its own risk aversion. The equilibrium prices of goods in this market represent aggregate beliefs. For agents with constant risk aversion, we demonstrate that the aggregate probability exhibits several desirable properties, and is related to independently motivated techniques. We argue that the market-based approach provides a plausible mechanism for belief aggregation in multiagent systems, as it directly addresses self-motivated agent incentives for participation and for truthfulness, and can provide a decision-theoretic foundation for the "expert weights" often employed in centralized pooling techniques.
    Date: 2013–02
  8. By: Ghosal, Sayantan (University of Warwick); Dalton, Patricio (Tilberg University)
    Abstract: This paper provides an axiomatic characterization of choices in a setting where a decision-maker may not fully internalize all the consequences of her choices on herself. Such a departure from rationality, it turns out, is common across a variety of positive behavioral models and admits the standard rational choice model as a special case. We show that choice data satisfying (a) Sen’s axioms and fully characterize behavioral decisions, and (b) Sen’s axiom and fully characterize standard decision-making. In addition, we show that (a) it is possible to identify a minimal and a maximal set of psychological states using choice data alone, and (b) under specific choice scenarios, "revealed mistakes" can be inferred directly from choice data.
    Keywords: Behavioral Decisions, Revealed and Normative Preferences, Welfare, Axiomatic characterization
    Date: 2013
  9. By: Krzysztof Piasecki
    Abstract: The main goal of this paper is presentation a modern axiomatic approach to financial arithmetic. At the first, the axiomatic financial arithmetic theory was proposed by Peccati who has introduced the axiomatic definition of the future value. This theory has been extensively developed in past years. Proposed approach to financial arithmetic is based on the financial flow utility concept. This utility function is defined as linear extension of multicriteria comparison determined by the time preference and the capital preference. Then the present value is equal to financial flow utility. Therefore, the law of diminishing marginal wealth utility has been considered as additional feature of the present value. The future value is defined as the inverse of utility function. This definition is a generalization of the Peccati one. The net present value is given as the unique additive extension of financial flow utility. Moreover, the synergy effect and the diversification effect will be discussed. At the end, the axiomatic present value definition will be specified in three ways.
    Date: 2013–02
  10. By: Yun, Tack; Kim, Jinsook; Ko, Eunmi
    Abstract: Our goal in this paper is two-fold. First, we develop a class of term structure models that allow for the role of bounded rationality by incorporating either information-processing constraint or fear for mis-specification into affine term structure models. We indentify a set of sufficient conditions to generate the observational equivalence between affine term-structure models with rational inattention and a fear for model misspecification. The presence of bounded rationality creates a new additional factor that is not spanned by conventional factors such as level, slope, and curvature factors. Second, our empirical results indicate that substantial amounts of information capacity constraint and robustness preference for model misspecification are needed to explain the observed behavior of yields.
    Keywords: Rational Inattention; Robustness; Affine Term Structure Models; No-Arbitrage
    JEL: E43 G11 G12 E44
    Date: 2012–10–01
  11. By: Vassalos, Michael; Hu, Wuyang; Woods, Timothy A.; Schieffer, Jack; Dillon, Carl R.
    Abstract: Growers’ preferences for a number of marketing contract attributes as well as the effect of growers’ risk perception and risk preferences on the choice of marketing contracts were examined with the use of a choice experiment. The main data source for the study is a mail survey administrated to 315 wholesale tomato growers. The findings validate the transaction cost hypothesis and indicate heterogeneity in preferences. Risk perception and risk preferences had limited impact on contract choice.
    Keywords: Marketing Contracts, transaction costs, choice of contracts, choice experiment, Agribusiness, Farm Management, Marketing, Q12, Q13,
    Date: 2013–01–10
  12. By: Awondo, Sebastain N.; Datta, Gauri S.; Ramirez, Octavio A.; Fonsah, Esendugue Greg
    Abstract: The magnitude of basis risk between Actual Production History (APH) and Group Risk Plan (GRP) contracts across corn farms in Illinois counties is estimated using pseudo-simulated yields with farm specific geospatial climate data. A two-step hierarchical Bayes small area estimator was used to address problems related to lack of representative sample, aggrega- tion bias, properly accounting for spatial and temporal heterogeneity and uncertainty in parameter estimates. We found wide variation in expected basis risk across farms within and between counties. Expected basis risk was found to sharply increase under APH plans with higher coverage levels.
    Keywords: Crop Insurance, Basis risk, Small area estimation, Hierarchical Bayes, Agricultural Finance, Research Methods/ Statistical Methods,
    Date: 2013–02

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