nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2013‒09‒24
twelve papers chosen by
Alexander Harin
Modern University for the Humanities

  1. (Ir)rational Exuberance: Optimism, Ambiguity, and Risk By Anat Bracha; Donald Brown
  2. Collective risk aversion. By Jouini, Elyès; Napp, Clotilde; Nocetti, Diego
  3. The Endowment Effect By Keith M. Marzilli Ericson; Andreas Fuster
  4. Evidence for countercyclical risk aversion: an experiment with financial professionals By Alain Cohn; Jan Engelmann; Ernst Fehr; Michel Maréchal
  5. Hedging under an expected loss constraint with small transaction costs By Bruno Bouchard; Ludovic Moreau; Mete H. Soner
  6. Bootstraps for Meta-Analysis with an Application to the Impact of Climate Change By Richard S.J. Tol
  7. A link based network route choice model with unrestricted choice set By Fosgerau, Mogens; Frejinger, Emma; Karlström, Anders
  8. Learning, Expectations, and Endogenous Business Cycles By Doshchyn, Artur; Giommetti, Nicola
  9. 'Entrepreneurs, Risk Aversion and Dynamic Firms' By Neus Herranz,; Stefan Krasa,; Anne P. Villamil
  10. Understanding Peer Effects in Financial Decisions: Evidence from a Field Experiment By Noam Yuchtman; Florian Ederer; Bruno Ferman; Leonardo Bursztyn
  11. To defer or not defer? State Pension in a Lifecycle Model By Ricky Kanabar; Peter Simmons
  12. Behavioral Implications of Rational Inattention with Shannon Entropy By Andrew Caplin; Mark Dean

  1. By: Anat Bracha; Donald Brown
    Date: 2013–09–19
  2. By: Jouini, Elyès; Napp, Clotilde; Nocetti, Diego
    Abstract: In this paper we analyse the risk attitude of a group of heterogenous agents and we develop a theory of comparative collective risk tolerance. In particular, we characterize how shifts in the distribution of individual levels of risk tolerance affect the representative agent's degree of risk tolerance. In the model with efficient risk – sharing and two agents (e.g. a household) with isoelastic preferences we show that an increase of the level of risk tolerance of one of the agents might have an ambiguous impact on the aggregate level of risk tolerance; the latter increases for some levels of aggregate wealth while it decreases for other levels of aggregate wealth. Specifically, there are two possible shapes for aggregate risk tolerance as a function of the risk tolerance level of one of the agents: increasing curve or increasing then decreasing curve. For more general populations we characterize the effect of first order like shifts (individual levels of risk tolerance more concentrated on high values) and second order like shifts (more dispersion on individual levels of risk tolerance) on the collective level of risk tolerance. We also evaluate how shifts in the distribution of individual levels of risk tolerance impact the collective level of risk tolerance in a framework with exogenous egalitarian sharing rules. Our results permit to better characterize differences in risk taking behavior between groups and individuals and among groups with different distribution of risk preferences.
    Keywords: collective risk; heterogenous agents; risk tolerance; isoelastic preferences; aggregate wealth; risk preferences;
    JEL: D1 D81
    Date: 2013
  3. By: Keith M. Marzilli Ericson; Andreas Fuster
    Abstract: The endowment effect is among the best known findings in behavioral economics, and has been used as evidence for theories of reference-dependent preferences and loss aversion. However, a recent literature has questioned the robustness of the effect in the laboratory, as well as its relevance in the field. In this review, we provide a summary of the evidence, and describe recent theoretical developments that can potentially reconcile the different findings, with a focus on expectation-based reference points. We also survey recent work from psychology that provides either alternatives to or refinements of the usual loss aversion explanation. We argue that loss aversion is still the leading paradigm for understanding the endowment effect, but that given the rich psychology behind the effect, a version of the theory that encompasses multiple reference points may be required.
    JEL: C91 D03 D11 D87
    Date: 2013–08
  4. By: Alain Cohn; Jan Engelmann; Ernst Fehr; Michel Maréchal
    Abstract: A key ingredient of many popular asset pricing models is that investors exhibit countercyclical risk aversion, which helps explain major puzzles in financial economics such as the strong and systematic variation in risk premiums over time and the high volatility of asset prices. There is, however, surprisingly little evidence for this assumption because it is difficult to control for the host of factors that change simultaneously during financial booms and busts. We circumvent these control problems by priming financial professionals with either a boom or a bust scenario and by subsequently measuring their risk aversion in two experimental investment tasks with real monetary stakes. Subjects who were primed with a financial bust were substantially more risk averse than those who were primed with a boom. Subjects were also more fearful in the bust than in the boom condition, and their fear is negatively related to investments in the risky asset, suggesting that fear may play an important role in countercyclical risk aversion. The mechanism described in this paper is relevant for theory and has important implications for financial markets, as it provides the basis for a self-reinforcing process that amplifies market dynamics.
    Keywords: Countercyclical risk aversion, experiment, financial professionals
    JEL: G02 C91
    Date: 2013–08
  5. By: Bruno Bouchard (CEREMADE, CREST); Ludovic Moreau; Mete H. Soner
    Abstract: We consider the problem of option hedging in a market with proportional transaction costs. Since super-replication is very costly in such markets, we replace perfect hedging with an expected loss constraint. Asymptotic analysis for small transactions is used to obtain a tractable model. A general expansion theory is developed using the dynamic programming approach. Explicit formulae are also obtained in the special cases of an exponential or power loss function. As a corollary, we retrieve the asymptotics for the exponential utility indifference price.
    Date: 2013–09
  6. By: Richard S.J. Tol (Department of Economics, University of Sussex; Institute for Environmental Studies, Vrije Universiteit, Amsterdam, The Netherlands; Department of Spatial Economics, Vrije Universiteit, Amsterdam, The Netherlands; Tinbergen Institute, Amsterdam, The Netherlands)
    Abstract: Bootstrap and smoothed bootstrap methods are used to estimate the uncertainty about the total impact of climate change, and to assess the performance of commonly used impact functions. Kernel regression is extended to include restrictions on the functional form. Impact functions do not describe the primary estimates of the economic impacts very well, and monotonic functions do particularly badly. The impacts of climate change do not significantly deviate from zero until 2.5-3.5°C warming. The uncertainty is large, and so is the risk premium. The ambiguity premium is small, however. The certainty equivalent impact is a negative 1.5% of income for 2.5°C, rising to 15% (50%) for 5.0°C for a rate of risk aversion of 1 (2).
    Keywords: impacts of climate change, kernel regression, bootstrap, risk aversion, ambiguity aversion
    JEL: C14 Q54
    Date: 2013–09
  7. By: Fosgerau, Mogens (DTU TRANSPORT); Frejinger, Emma (KTH); Karlström, Anders (KTH)
    Abstract: This paper considers the path choice problem, formulating and discussing an econometric random utility model for the choice of path in a network with no restriction on the choice set. Starting from a dynamic specification of link choices we show that it is equivalent to a static model of the multinomial logit form but with infinitely many alternatives. The model can be consistently estimated and used for prediction in a computationally efficient way. Similarly to the path size logit model, we propose an attribute called link size that corrects utilities of overlapping paths but that is link additive. The model is applied to data recording path choices in a network with more than 3,000 nodes and 7,000 links.
    Keywords: Discrete choice; Recursive logit; Networks; Route choice; Infinite choice set
    JEL: R40
    Date: 2013–09–16
  8. By: Doshchyn, Artur; Giommetti, Nicola
    Abstract: We show that business cycles can emerge and proliferate endogenously in the economy due to the way economic agents learn, form their expectations, and make decisions regarding savings and production for future periods. There are no exogenous shocks of any kind to productivity or any other fundamental parameters of the economy, in contrast to Real Business Cycle models. To our knowledge this thesis is the first attempt to formally introduce adaptive learning and expectation errors as an autonomous source of endogenous business cycles. We develop a simple, growth-less macroeconomic model, in which agents do not have perfect foresight, learn adaptively to form expec- tations, and solve limited inter-temporal optimization models. The theoretical possibility of cycles largely arises from the nonlinearity of the actual law of motion of price, in particular from the fact that agents always overpredict (underpredict) future prices when they are higher (lower) than equilibrium level. Even though the main version of the model is based on households having a simple logarithmic utility func- tion, we also show that the results hold when a more generic Hyperbolic Absolute Risk Aversion utility function is chosen. Money stock is neutral in the long run in either case. We conduct simulations in models with agents having both simple logarithmic and HARA utility functions. Following Thomas Sargent (1993), we assume agents to be “rational econometricians” using various econometric adaptive learning tools: Auto ARIMA, VAR and AR(2) models. In all simulations, output and other economic variables indeed display cyclical fluctuations around their equilibrium levels. Both converging and diverging cycles may be obtained in simulations with Auto ARIMA models, while the VAR learning tool leads to diverging fluctuations in the majority of cases, suggesting that making agents consider several variables increases instability, at least in our setting. It is also observed that higher frequency of model switching is usually accompanied with increasing amplitude of cycles, suggesting the hypothesis that economic crises may happen when agents make drastic revisions of their beliefs about how the economy works. Only converging cycles can be obtained with AR(2), however in this case the economy may get trapped in a so called “false equilibrium”, with output way below or above the true equilibrium level. Even though this is not formally an equilibrium, the convergence towards the true one is so slow that exogenous shocks may be needed to move the economy back on track. This result is in line with the Keynesian view that the economy may remain in a depressed state for quite a long period of time, and active government intervention may be required to speed up the recovery. Within the developed framework we analyze whether active mone- tary policy (i.e. changes in money stock) can be used for stabilization purposes. It turns out that in the simple case, when agents have loga- rithmic utility function, shifts in money supply can have real effects on the economy only if they are unexpected by agents, or if future price expectations are not adjusted exactly proportionally to the announced monetary interventions. We also show that the second case is not sus- tainable within the adaptive learning environment, so that monetary policy may become ineffective in the long run when, and if, learning is complete. We prove, however, that monetary interventions always have real effects in the short run in the setting with a more generic HARA utility function. Still, it is highly questionable whether the central bank is able to accurately assess the consequences of its own actions, as that would require it knowing precisely the actual law of motion of the economy, current market’s expectations, and agents’ reaction to news about the upcoming monetary interventions, which, moreover, can change over time.
    Keywords: learning; expectations; endogenous business cycles; monetary policy;
    JEL: D83 D84 E32 E37 E52
    Date: 2013–08
  9. By: Neus Herranz,; Stefan Krasa,; Anne P. Villamil
    Abstract: This paper conducts a theoretical and quantitative analysis of how entrepreneurs choose firm size, capital structure, default, and owner consumption to manage firm risk, including how these choices change with risk aversion. We decompose an entrepreneur’s default decision into three elements: the fraction of firm debt; the potential reduction in personal consumption from losing the firm; and the ratio of personal wealth to firm scale, which determines an entrepreneur’s ability to inject personal funds to continue operation. Data from the Survey of Small Business Finances is used to calibrate the model and estimate entrepreneur risk aversion. We determine the evolution of entrepreneur net worth, consumption, and firm assets over time. We find that many entrepreneurs have lower net worth and consumption than non-entrepreneurs with the same preferences, but the densities of the distributions of consumption and net-worth have wide upper tails. Thus, entrepreneurship can be a path toward great wealth and high consumption for the top quantiles of entrepreneurs.
    Date: 2013
  10. By: Noam Yuchtman (UC Berkeley); Florian Ederer (UCLA); Bruno Ferman (The George Washington University); Leonardo Bursztyn (UCLA)
    Abstract: Using a high-stakes field experiment conducted with a financial brokerage, we implement a novel design to separately identify two channels of social influence in financial decisions, both widely studied theoretically. When someone purchases an asset, his peers may also want to purchase it, both because they learn from his choice ("social learning") and because his possession of the asset directly affects others' utility of owning the same asset ("social utility"). We find that both channels have statistically and economically significant effects on investment decisions. These results can help shed light on the mechanisms underlying herding behavior in financial markets.
    Date: 2013
  11. By: Ricky Kanabar; Peter Simmons
    Abstract: The UK state pension (which depends only on age) includes an option to defer take up which yields either a subsequent lump sum or higher weekly pension. We analyse the joint decisions on pension deferral and intertemporal labour supply/participation in a life cycle setting. We show that deferral is purely a financial decision, but the impact of deferral on work decisions depends on preferences, wage rates, non-labour income and initial wealth. To exactly characterise this we use a quasilinear utility function, and provide calibrated simulations. We also discuss the choice between a lump sum or increased weekly pension
    Keywords: Retirement, Labour Supply, Ageing, UK State Pension
    JEL: J14 J18 J22 J26
    Date: 2013–09
  12. By: Andrew Caplin; Mark Dean
    Abstract: The model of rational inattention with Shannon mutual information costs is increasingly ubiquitous. We introduce a new solution method that lays bare the general behavioral properties of this model and liberates development of alternative models. We experimentally test a key behavioral property characterizing the elasticity of choice mistakes with respect to attentional incentives. We find that subjects are less responsive to such changes than the model implies. We introduce generalized entropy cost functions that better match this feature of the data and that retain key simplifying features of the Shannon model.
    JEL: D83
    Date: 2013–08

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