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on Utility Models and Prospect Theory |
| By: | Bhamra, Harjoat Singh; Uppal, Raman |
| Abstract: | In this paper, we study asset prices in a dynamic, continuous-time, general-equilibrium endowment economy where agents have “catching up with the Joneses” utility functions and differ with respect to their beliefs (because of differences in priors) and their preference parameters for time discount, risk aversion, and sensitivity to habit. A key contribution of our paper is to demonstrate how one can obtain a closed-form solution to the consumption-sharing rule for agents who have both heterogeneous priors and heterogeneous preferences without restricting the risk aversion of the two agents to special values. We solve in closed form also for the the state-price density, the riskless interest rate and market price of risk; the stock price, equity risk premium, and volatility of stock returns; the term structure of interest rates; and the conditions necessary to obtain a stationary equilibrium in which both agents survive in the long run. The methodology we develop is sufficiently general that, as long as markets are complete, it can be used to obtain the sharing rule and state prices for models set in discrete or continuous time and for arbitrary endowment and belief updating processes. |
| Keywords: | Asset Pricing; General Equilibrium |
| JEL: | G11 G12 |
| Date: | 2013–05 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:9459&r=upt |
| By: | Guillermo Baquero (ESMT European School of Management and Technology); Willem Smit (SMU, IMD); Luc Wathieu (Georgetown University, McDonough School of Business) |
| Abstract: | We explore the interaction between fairness attitudes and reference dependence both theoretically and experimentally. Our theory of fairness behavior under reference-dependent preferences in the context of ultimatum games, defines fairness in the utility domain and not in the domain of dollar payments. We test our model predictions using a within-subject design with ultimatum and dictator games involving gains and losses of varying amounts. Proposers indicated their offer in gain- and (neatly comparable) loss- games; responders indicated minimum acceptable gain and maximum acceptable loss. We find a significant “generosity effect” in the loss domain: on average, proposers bear the largest share of losses as if anticipating responders’ call for a smaller share. In contrast, reference dependence hardly affects the outcome of dictator games -where responders have no veto right- though we detect a small but significant “compassion effect”, whereby dictators are on average somewhat more generous sharing losses than sharing gains. |
| Keywords: | Fairness, loss domain, ultimatum game, dictator game, referencedependent preferences, social preferences |
| JEL: | D03 D81 |
| Date: | 2013–08–29 |
| URL: | http://d.repec.org/n?u=RePEc:esm:wpaper:esmt-13-08&r=upt |
| By: | Bales, Adam; Cohen, Daniel; Handfield, Toby |
| Abstract: | Orthodox decision theory gives no advice to agents who hold two goods to be incommensurate in value because such agents will have incomplete preferences. According to standard treatments, rationality requires complete preferences, so such agents are irrational. Experience shows, however, that incomplete preferences are ubiquitous in ordinary life. In this paper, we aim to do two things: (1) show that there is a good case for revising decision theory so as to allow it to apply non-vacuously to agents with incomplete preferences, and (2) to identify one substantive criterion that any such non-standard decision theory must obey. Our criterion, Competitiveness, is a weaker version of a dominance principle. Despite its modesty, Competitiveness is incompatible with prospectism, a recently developed decision theory for agents with incomplete preferences. We spend the final part of the paper showing why Competitiveness should be retained, and prospectism rejected. |
| Keywords: | Decision theory, incommensurate value, practical reason, incomplete preferences, dominance |
| JEL: | D01 D03 D81 D89 |
| Date: | 2013–09–09 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:49954&r=upt |
| By: | Matsuki, Jun; Tadenuma, Koichi |
| Abstract: | In this paper, we consider a natural procedure of decision-making, called a “Grouping Choice Method”, which leads to a kind of bounded rational choices. In this procedure a decision-maker (DM) first divides the set of available alternatives into some groups and in each group she chooses the best element (winner) for her preference relation. Then, among the winners in the first round, she selects the best one as her final choice. We characterize Grouping Choice Methods in three different ways. First, we show that a choice function is a Grouping Choice Method if and only if it is a Rational Shortlist Method (Manzini and Mariotti, 2007) in which the first rationale is transitive. Second, Grouping Choice Methods are axiomatically characterized by means of a new axiom called Elimination, in addition to two well-known axioms, Expansion and Weak WARP (Manzini and Mariotti, 2007). Third, Grouping Choice Methods are also characterized by a weak version of Path Independence. |
| Keywords: | grouping of alternatives, preference, bounded rationality |
| JEL: | D01 |
| Date: | 2013–09 |
| URL: | http://d.repec.org/n?u=RePEc:hit:ccesdp:52&r=upt |
| By: | Benjamin R. Handel; Jonathan T. Kolstad |
| Abstract: | Traditional models of insurance choice are predicated on fully informed and rational consumers protecting themselves from exposure to financial risk. In practice, choosing an insurance plan from a set of complex non-linear contracts is a complicated decision often made without full information on several potentially important dimensions. In this paper we combine new administrative data on health plan choices and claims with unique survey data on consumer information and other typically unobserved preference factors in order to separately identify risk preferences, information frictions, and perceived plan hassle costs. The administrative and survey data are linked at the individual level, allowing in-depth investigations of the links between these micro- foundations in both descriptive and choice-model based analyses. We find that consumers lack information on many important dimensions that they are typically assumed to understand, perceive high plan hassle costs, and make choices that depend on these frictions. Moreover, in the context of an expected utility model, including the additional frictions that we measure has direct implications for risk preference estimates, which are typically assumed to be the only source of persistent unobserved preference heterogeneity in such models. In our setting, we show that incorporating measures of these frictions leads to meaningful reductions in estimated consumer risk aversion. This result has both positive and normative implications since risk aversion generally has different welfare implications than information frictions. We assess the welfare impact of a counterfactual menu design and find that the welfare loss from risk exposure when additional frictions are not taken into account is more than double that when they are, illustrating the potential importance of our analysis for policy decisions. |
| JEL: | D8 D83 G22 I13 |
| Date: | 2013–08 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:19373&r=upt |
| By: | Giuseppe Ciccarone; Francesco Giuli; Enrico Marchetti |
| Abstract: | We introduce some elements of Prospect Theory into a general equilibrium model with monopolistic competition in the good market and real wage rigidities due to (right to manage or efficient) wage bargaining, or to efficiency wages. We show that, under these types of labor market frictions, an increase in workers’ loss aversion: (i) reduces the equilibrium wage and in this way increases potential output; (ii) induces workers to work and consume less and in this way decreases potential output. If the former effect is greater (smaller) than the latter one, loss aversion increases(decreases) potential output. We also show that, under all the types of labor market frictions we consider, if loss aversion reduces equilibrium output, it also enhances the plausibility of nominal price rigidities. |
| Keywords: | Macroeconomic equilibrium; Prospect theory; Behavioral economics |
| JEL: | E20 D03 |
| Date: | 2013–09 |
| URL: | http://d.repec.org/n?u=RePEc:rtr:wpaper:0183&r=upt |
| By: | Guiso, Luigi; Sapienza, Paola; Zingales, Luigi |
| Abstract: | We use a repeated survey of an Italian bank’s clients to test whether investors’ risk aversion increases following the 2008 financial crisis. We find that both a qualitative and a quantitative measure of risk aversion increases substantially after the crisis. After considering standard explanations, we investigate whether this increase might be an emotional response (fear) triggered by a scary experience. To show the plausibility of this conjecture, we conduct a lab experiment. We find that subjects who watched a horror movie have a certainty equivalent that is 27% lower than the ones who did not, supporting the fear-based explanation. Finally, we test the fear-based model with actual trading behavior and find consistent evidence. |
| Keywords: | Fear; Financial Crisis; Risk Aversion |
| JEL: | D1 D8 G11 G12 |
| Date: | 2013–08 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:9589&r=upt |
| By: | Wayne E. Ferson; Jerchern Lin |
| Abstract: | The literature has not unambiguously established that a positive alpha, as traditionally measured, means that an investor would want to buy a fund. However, when alpha is defined using the client's marginal utility function, a client faced with a positive alpha would generally want to buy. When markets are incomplete performance measurement is inherently investor specific, and investors will disagree about the attractiveness of a given fund. We provide empirical bounds on the expected disagreement with a traditional alpha and study the cross sectional effects of disagreement and investor heterogeneity on the flow response to past fund alphas. The effects are both economically and statistically significant. |
| JEL: | G11 |
| Date: | 2013–08 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:19349&r=upt |
| By: | Bo Zhao |
| Abstract: | This paper studies an economy inhabited by overlapping generations of homeowners and investors, with the only difference between the two being that homeowners derive utility from housing services whereas investors do not. Tight collateral constraint limits the borrowing capacity of homeowners and drives the equilibrium interest rate level down to the housing price growth rate, which makes housing attractive as a store of value for investors. As long as the rental market friction is high enough, the investors will hold a positive number of vacant houses in equilibrium. A housing bubble arises in an equilibrium in which investors hold houses for resale purposes only and without the expectation of receiving a dividend either in terms of utility or rent. The model can be applied to China, where the housing bubble can be attributed to the rapid decline in the replacement rate of the pension system. |
| JEL: | D21 E13 E21 R21 |
| Date: | 2013–08 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:19354&r=upt |
| By: | Foster, Jarred; Krawczyk, Jacek B |
| Abstract: | This study builds on recent findings that target-based utility measures, used in the dynamic portfolio optimisation, deliver investment policies that can generate leftskewed payoff distributions. These policies can lead to small probabilities of low payoffs. This is in contrast to the classical portfolio optimisation strategies that commonly deliver right-skewed payoff distributions, which imply a high probability of losses. The left-skewed payoff distributions can be obtained when a “cautious-relaxed” investment policy is applied in portfolio management. Such a policy will be adopted by investors who are both cautious in seeking a payoff meeting a certain target, but relaxed toward the possibility of exceeding it. We use computational methods to analyse the effects of varying the target on the payoff distribution and also examine how the fund manager’s explicit preferences, when they differ from the investor’s, can impact the distribution. We found that increasing the target causes the distribution to become less left skewed. Lowering the target slightly, keeps the left-skewed payoff distribution albeit the mode diminishes. Decreasing the target substantially so it is below the safe investment payoff, changes the skew. Investor’s payoff will not suffer even if the actual fund manager allows for their own utility in the optimisation problem. |
| Keywords: | Investment policies, Portfolio management, Investment strategy, |
| Date: | 2013 |
| URL: | http://d.repec.org/n?u=RePEc:vuw:vuwecf:2972&r=upt |
| By: | Jean Guillaume Forand (University of Waterloo); Vikram Maheshri (University of Houston) |
| Abstract: | Regulation is a set of constraints imposed on transactions between buyers and sellers. We introduce a dynamic frictional matching model with horizontal differentiation and nontransferable utility in which a regulator determines permissible transactions. We show the existence and uniqueness of a market equilibrium for any level of regulation and characterize the regulator’s optimal choice of regulatory environment. We argue that in ‘thin’, markets, regulation can correct market failure arising from mismatch between buyers and sellers. However, in ‘thick’ markets, deregulation is optimal, as a regulator can rely on market participants’ equilibrium behavior instead of explicit constraints on economic activities. |
| Keywords: | Regulation, Search, Thickness, Horizontal Differentiation |
| JEL: | D L |
| Date: | 2013–09–06 |
| URL: | http://d.repec.org/n?u=RePEc:hou:wpaper:2013-252-38&r=upt |
| By: | Schultz Hansen, Kistian (Department of Global Health and Development); Hjernø Lesner, Tine (COHERE, Department of Budiness and Economics); Østerdal, Lars Peter (COHERE, Department of Business and Economics) |
| Abstract: | One of the most serious problems in the fight against malaria, especially in Africa, is the fact that many individuals suffering from malaria do not have easy access to effective antimalarials while at the same time a large proportion of people receiving antimalarials do not suffer from malaria. In order to improve access, a global price subsidy of 95% has been proposed for the most effective antimalarial, artemisininbased combination therapy (ACT). The objective of this proposal is to lower the consumer price on effective malaria medicine to increase access for, in particular, poor consumers. However, treatment of patients not suffering from malaria with antimalarials including ACTs has been proven widespread and a subsidy is likely to increase this overtreatment. This means waste of resources and will result in inflating the subsidy funds required. In addition, as has happened with older types of malaria medicine, treating nonmalarial fevers with malaria medicine may increase the risk of artemisinin resistance development. Diagnostic tests for malaria may have the potential for reducing overtreatment, but tests are expensive for the typical malaria treatmentseeking individual. In order to both increase access and reduce overtreatment we propose a subsidy on rapid diagnostic tests (RDTs) together with the ACT subsidy. The main objective of the paper is to investigate the optimal combination of subsidies that incentivises individuals suspecting themselves to have malaria to always test before buying an effective drug. We present a model that describes the health seeking behaviour of a representative individual using an expected utility framework. Based on numerical simulations of our model we find that a price reduction on RDTs is necessary to incentivise testing while at the same time, the subsidy on ACT can be lower than the proposed 95% without compromising access. The leastcost policy of the health policy maker is to subsidise both ACT and RDT, redirecting some of the subsidy money from ACT to RDT. |
| Keywords: | Health and economic development; public health; medical subsidy programmes; malaria; drug resistance |
| JEL: | H51 I15 O15 |
| Date: | 2013–09–10 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:sduhec:2013_008&r=upt |
| By: | Rozenberg, Julie; Vogt-Schilb, Adrien; Hallegatte, Stephane |
| Abstract: | This paper compares the temporal profile of efforts to curb greenhouse gas emissions induced by two mitigation strategies: a regulation of all emissions with a carbon price and a regulation of emissions embedded in new capital only, using capital-based instruments such as investment regulation, differentiation of capital costs, or a carbon tax with temporary subsidies on brown capital. A Ramsey model is built with two types of capital: brown capital that produces a negative externality and green capital that does not. Abatement is obtained through structural change (green capital accumulation) and possibly through under-utilization of brown capital. Capital-based instruments and the carbon price lead to the same long-term balanced growth path, but they differ during the transition phase. The carbon price maximizes social welfare but may cause temporary under-utilization of brown capital, hurting the owners of brown capital and the workers who depend on it. Capital-based instruments cause larger intertemporal welfare loss, but they maintain the full utilization of brown capital, smooth efforts over time, and cause lower immediate utility loss. Green industrial policies including such capital-based instruments may thus be used to increase the political acceptability of a carbon price. More generally, the carbon price informs on the policy effect on intertemporal welfare but is not a good indicator to estimate the impact of the policy on instantaneous output, consumption, and utility. |
| Keywords: | Climate Change Mitigation and Green House Gases,Economic Theory&Research,Climate Change Economics,Investment and Investment Climate,Emerging Markets |
| Date: | 2013–09–01 |
| URL: | http://d.repec.org/n?u=RePEc:wbk:wbrwps:6609&r=upt |