nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2013‒10‒18
twenty-one papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Source-Dependence of Utility and Loss Aversion: A Critical Test of Ambiguity Models By Mohammed Abdellaoui; Han Bleichrodt; Olivier L'Haridon; Dennie Van Dolder
  2. Separating attitudes towards money from attitudes towards probabilities: Stake effects and ambiguity as a test for prospect theory By Vieider, Ferdinand M.; Cingl, Lubomír; Martinsson, Peter; Stojic, Hrvoje
  3. Learning under ambiguity: An experiment using initial public offerings on a stock market By Aurélien Baillon; Han Bleichrodt; Umut Keskin; Olivier L'Haridon; Author-Name: Chen Li
  4. How Much Would You Pay to Resolve Long-Run Risk? By Larry G. Epstein; Emmanuel Farhi; Tomasz Strzalecki
  5. Measuring Time and Risk Preferences: Reliability, Stability, Domain Specificity By Riedl A.M.; Wölbert E.M.
  6. Revealed Preference Foundations of Expectations-Based Reference-Dependence By David Freeman
  7. Resource Allocation Contests: Experimental Evidence By Robert Shupp; Roman M. Sheremeta; David Schmidt; James Walker
  8. Reciprocity as the foundation of Financial Economics By Timothy C. Johnson
  9. Complexity and Bounded Rationality in Individual Decision Problems By Theodoros M. Diasakos
  10. Collective Dangerous Behavior: Theory and Evidence on Risk-Taking By Olivier Bochet; Jeremy Laurent-Lucchetti; Justin Leroux; Bernard Sinclair-Desgagné
  11. Optimistic versus Pessimistic--Optimal Judgemental Bias with Reference Point By Si Chen
  12. Risk taking and risk sharing does responsibility matter? By Tausch F.; Cettolin E.
  13. Inferring Rationales from Choice : Identification for Rational Shortlist Methods By Rohan Dutta; Sean Horan
  14. Properties of a risk measure derived from the expected area in red By Stéphane Loisel; Julien Trufin
  15. External Habit in a Production Economy By Chen, Andrew Y.
  16. Evaluating the Interaction between Farm Programs with Crop Insurance and Producers' Risk Preferences By Davis, Todd D.; Anderson, John D.; Young, Robert E.
  17. Implications of labor market frictions for risk aversion and risk premia By Eric T. Swanson
  18. Migration Between Platforms By Gary Biglaiser; Jacques CreÌmer; AndreÌ Veiga
  19. Ending the myth of the St Petersburg paradox By Robert William, Vivian
  20. The principal problem in political economy: income distribution in the history of economic thought. By Sandmo, Agnar
  21. On optimal emission control – Taxes, substitution and business cycles By Lintunen , Jussi; Vilmi, Lauri

  1. By: Mohammed Abdellaoui (HEC Paris and GREGHEC CNRS); Han Bleichrodt (Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE), the Netherlands); Olivier L'Haridon (CREM UMR CNRS 6211 and GREGHEC, University of Rennes 1, France); Dennie Van Dolder (Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE))
    Abstract: This paper tests whether utility is the same for risk and for uncertainty. This test is critical for models that capture ambiguity aversion through a difference in event weighting between risk and uncertainty, like the multiple priors models and prospect theory. We present a new method to measure utility and loss aversion under uncertainty without the need to introduce simplifying parametric assumptions. Our method extends Wakker and Deneffe’s (1996) trade‐off method by allowing for standard sequences that include gains, losses, and the reference point. It provides an efficient way to measure loss aversion and a useful tool for practical applications of ambiguity models. We could not reject the hypothesis that utility and loss aversion were the same for risk and uncertainty, suggesting that utility primarily reflects attitudes towards outcomes. Utility was S‐shaped, concave for gains and convex for losses and there was substantial loss aversion. Our findings support models that explain ambiguity aversion through a difference in event weighting and suggest that descriptive ambiguity models should allow for reference‐dependence of utility.
    Keywords: prospect theory, loss aversion, utility for gains and losses, probability distortion, decision analysis, risk aversion
    Date: 2013–07
  2. By: Vieider, Ferdinand M.; Cingl, Lubomír; Martinsson, Peter; Stojic, Hrvoje
    Abstract: Prospect theory (PT) is the dominant descriptive theory of decision making under risk today. For the modeling of choices, PT relies on a psychologically founded separation of risk attitudes into attitudes towards outcomes, captured in a value function; and attitudes towards probabilities, captured in a probability weighting function. However, while it is theoretically sound, it is unclear whether this clear separation is reflected in actual choices. To test this, we designed two experiments. In the first experiment, we elicit the value and probability weighting functions both under known and unknown probabilities. The results support PT and show that the value function is unaffected by the nature of the probabilities, which only affects probability weighting. More in general, this finding supports theories that represent ambiguity attitudes through probability transformations rather than utility transformations. In the second experiment, we examine the effects of an increase in stakes on risk attitudes. We find that the stake increase is not reflected in the value function, but rather in the weighting function, thus contradicting PT's prediction. --
    Keywords: prospect theory,value functions,probability weighting,risk attitudes,ambiguity aversion,modeling of preferences
    JEL: C91 D03 D81
    Date: 2013
  3. By: Aurélien Baillon (Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE), the Netherlands); Han Bleichrodt (Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE), the Netherlands); Umut Keskin (Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE), the Netherlands); Olivier L'Haridon (CREM UMR CNRS 6211, University of Rennes 1, France); Author-Name: Chen Li (Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE), the Netherlands)
    Abstract: This paper studies the effect of learning new information on decision under uncertainty.Using ambiguity models, we show the effect of learning on beliefs and ambiguity attitudes. We develop a new method to correct beliefs for ambiguity attitudes and decompose ambiguity attitudes into pessimism (capturing ambiguity aversion) and likelihood insensitivity. We apply our method in an experiment using initial public offerings (IPOs) on the New York Stock Exchange. IPOs provide a natural decision context in which no prior information on returns is available. We found that likelihood insensitivity decreased with information, but pessimism was unaffected. Subjects moved in the direction of expected utility with more information, but significant deviations remained. Subjective probabilities,corrected for ambiguity attitudes, were well calibrated and close to market data.
    Keywords: ambiguity, learning, updating, neo-additive weighting
    JEL: D81
    Date: 2013–08
  4. By: Larry G. Epstein; Emmanuel Farhi; Tomasz Strzalecki
    Abstract: Though risk aversion and the elasticity of intertemporal substitution have been the subjects of careful scrutiny when calibrating preferences, the long-run risks literature as well as the broader literature using recursive utility to address asset pricing puzzles have ignored the full implications of their parameter specifications. Recursive utility implies that the temporal resolution of risk matters and a quantitative assessment of how much it matters should be part of the calibration process. This paper gives a sense of the magnitudes of implied timing premia. Its objective is to inject temporal resolution of risk into the discussion of the quantitative properties of long-run risks and related models.^@
    Date: 2013–07
  5. By: Riedl A.M.; Wölbert E.M. (GSBE)
    Abstract: To accurately predict behavior economists need reliable measures of individual time preferences and attitudes toward risk and typically need to assume stability of these characteristics over time and across decision domains. We test the reliability of two choice tasks for eliciting discount rates, risk aversion, and probability weighting and assess the stability of these characteristics over timeand across situations. We find high reliability and that individual characteristics are remarkably stable over time. The estimated parameters correlate well with self-reported decisions in financial domains, but are largely uncorrelated with decisions in other important life domains involving intertemporal trade-offs and risk.
    Keywords: Methodological Issues: General; Design of Experiments: Laboratory, Individual; Behavioral Economics: Underlying Principles; Information, Knowledge, and Uncertainty: General; Intertemporal Choice and Growth: General;
    JEL: C18 C91 D03 D80 D90
    Date: 2013
  6. By: David Freeman (Simon Fraser University)
    Abstract: This paper provides revealed preference foundations for a model of expectations based reference-dependence a la Koszegi and Rabin (2006). Novel axioms provide distinguishing features of expectations-based reference-dependence under risk. The analysis completely characterizes the model’s testable implications when expectations are unobservable.
    Keywords: Reference-dependent preferences, expectations as the reference point, preferred personal equilibrium, choice under risk
    JEL: D81
    Date: 2013–09
  7. By: Robert Shupp (Department of Agricultural, Food and Resource Economics, Michigan State University); Roman M. Sheremeta (Argyros School of Business and Economics, Chapman University); David Schmidt (Federal Trade Commission, Bureau of Economics); James Walker (Indiana University, Department of Economics)
    Abstract: Many resource allocation contests have the property that individuals undertake costly actions to appropriate a potentially divisible resource. We design an experiment to compare individuals’ decisions across three resource allocation contests which are isomorphic under riskneutrality. The results indicate that in aggregate the single-prize contest generates lower expenditures than either the proportional-prize or the multi-prize contest. Interestingly, while the aggregate results indicate similar behavior in the proportional-prize and multi-prize contests, individual level analysis indicates that the behavior in the single-prize contest is more similar to the behavior in the multi-prize contest than in the proportional-prize contest. We also elicit preferences toward risk, ambiguity and losses, and find that while such preferences cannot explain individual behavior in the proportional-prize contest, preferences with regard to losses are predictive of behavior in both the single-prize and multiple-prize contests. Therefore, it appears that loss aversion is correlated with behavior in the single-prize and multi-prize contests where losses are likely to occur, but not in the proportional-prize contest where losses are unlikely.
    Keywords: contest, rent-seeking, experiments, risk aversion, game theory
    JEL: C72 C92 D72
    Date: 2013
  8. By: Timothy C. Johnson
    Abstract: This paper argues that the fundamental principle of contemporary financial economics is balanced reciprocity, not the principle of utility maximisation that is important in economics more generally. The argument is developed by analysing the mathematical Fundamental Theory of Asset Pricing with reference to the emergence of mathematical probability in the seventeenth century in the context of the ethical assessment of commercial contracts. This analysis is undertaken within a framework of Pragmatic philosophy and Virtue Ethics. The purpose of the paper is to mitigate future financial crises by reorienting financial economics to emphasise the objectives of market stability and social cohesion rather than individual utility maximisation.
    Date: 2013–10
  9. By: Theodoros M. Diasakos (University of St Andrews)
    Abstract: I develop a model of endogenous bounded rationality due to search costs, arising implicitly from the problem's complexity. The decision maker is not required to know the entire structure of the problem when making choices but can think ahead, through costly search, to reveal more of it. However, the costs of search are not assumed exogenously; they are inferred from revealed preferences through her choices. Thus, bounded rationality and its extent emerge endogenously: as problems become simpler or as the benefits of deeper search become larger relative to its costs, the choices more closely resemble those of a rational agent. For a fixed decision problem, the costs of search will vary across agents. For a given decision maker, they will vary across problems. The model explains, therefore, why the disparity, between observed choices and those prescribed under rationality, varies across agents and problems. It also suggests, under reasonable assumptions, an identifying prediction: a relation between the benefits of deeper search and the depth of the search. As long as calibration of the search costs is possible, this can be tested on any agent-problem pair. My approach provides a common framework for depicting the underlying limitations that force departures from rationality in different and unrelated decision-making situations. Specifically, I show that it is consistent with violations of timing independence in temporal framing problems, dynamic inconsistency and diversification bias in sequential versus simultaneous choice problems, and with plausible but contrasting risk attitudes across small- and large-stakes gambles.
  10. By: Olivier Bochet; Jeremy Laurent-Lucchetti; Justin Leroux; Bernard Sinclair-Desgagné
    Abstract: It is commonly found that uncertainty helps discipline economic agents in strategic contexts. Using a stochastic variant of the Nash Demand Game, we show that the presence of uncertainty may have a dramatically opposite effect. Cautious (efficient) and dangerous (inefficient) equilibria may co-exist regardless of agents’ risk preferences. We report experimental evidence on these predictions. We find that a risk-taking society may emerge from the decentralized actions of risk-averse individuals. Subjects predominantly play symmetric dangerous equilibria, even when all agents are risk averse. An important driver for this result is the pessimistic beliefs of subjects regarding others’ claims.
    Date: 2013–10
  11. By: Si Chen
    Abstract: This paper develops a model of reference-dependent assessment of subjective beliefs in which loss-averse people optimally choose the expectation as the reference point to balance the current felicity from the optimistic anticipation and the future disappointment from the realisation. The choice of over-optimism or over-pessimism depends on the real chance of success and optimistic decision makers prefer receiving early information. In the portfolio choice problem, pessimistic investors tend to trade conservatively, however, they might trade aggressively if they are sophisticated enough to recognise the biases since low expectation can reduce their fear of loss.
    Date: 2013–10
  12. By: Tausch F.; Cettolin E. (GSBE)
    Abstract: Risk sharing arrangements diminish individuals vulnerability to probabilistic events that negatively affect their financial situation. This is because risk sharing implies redistribution, as lucky individuals support the unlucky ones. We hypothesize that responsibility for risky choices decreases individuals willingness to share risk by dampening redistribution motives, and investigate this conjecture with a laboratory experiment. Responsibility is created by allowing participants to choose between two different risky lotteries before they decide how much risk they share with a randomly matched partner. Risk sharing is then compared to a treatment where risk exposure is randomly assigned. We find that average risk sharing does not depend on whether individuals can control their risk exposure. However, we observe that when individuals are responsible for their risk exposure, risk sharing decisions are systematically conditioned on the risk exposure of the sharing partner, whereas this is not the case when risk exposure is random.
    Date: 2013
  13. By: Rohan Dutta; Sean Horan
    Abstract: A wide variety of choice behavior inconsistent with preference maximization can be explained by Manzini and Mariotti's Rational Shortlist Methods. Choices are made by sequentially applying a pair of asymmetric binary relations (rationales) to eliminate inferior alternatives. Manzini and Mariotti's axiomatic treatment elegantly describes which behavior can be explained by this model. However, it leaves unanswered what can be inferred, from observed behavior, about the underlying rationales. Establishing this connection is fundamental not only for applied and empirical work but also for meaningful welfare analysis. Our results tightly characterize the surprisingly rich relationship between behavior and the underlying rationales.
    Keywords: Revealed Preference; Identification; Uniqueness; Two-stage Choice Procedures; Behavioral Industrial Organization; Comparative Advertising; Decoy Marketing; Welfare.
    JEL: D01
    Date: 2013
  14. By: Stéphane Loisel (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Julien Trufin (Ecole d'Actuariat - Université Laval)
    Abstract: This paper studies a new risk measure derived from the expected area in red introduced in Loisel (2005). Specifically, we derive various properties of a risk measure defined as the smallest initial capital needed to ensure that the expected time-integrated negative part of the risk process on a fixed time interval [0; T] (T can be infinite) is less than a given predetermined risk limit. We also investigate the optimal risk limit allocation: given a risk limit set at company level for the sum of the expected areas in red of all lines, we determine the way(s) to allocate this risk limit to the subsequent business lines in order to minimize the overall capital needs.
    Keywords: Ruin probability; risk measure; expected area in red; stochastic ordering; risk limit
    Date: 2013–10–04
  15. By: Chen, Andrew Y. (OH State University)
    Abstract: A unified framework for understanding asset prices and aggregate fluctuations is critical for understanding both issues. I show that a real business cycle model with external habit preferences and capital adjustment costs provides one such framework. The estimated model matches the first two moments of the equity premium and risk-free rate, return and dividend predictability regressions, and the second moments of output, consumption, and investment. The model also endogenizes a key mechanism of consumption-based asset pricing models. In order to address the Shiller volatility puzzle, external habit, long-run risk, and disaster models require the assumption that the volatility of marginal utility is countercyclical. In the model, this countercyclical volatility arises endogenously. Production makes precautionary savings effects show up in consumption. These effects lead to countercyclical consumption volatility and countercyclical volatility of marginal utility. External habit amplifies this channel and makes it quantitatively significant.
    JEL: E21 E30 G12
    Date: 2013–10
  16. By: Davis, Todd D.; Anderson, John D.; Young, Robert E.
    Abstract: A stochastic simulation model is used to simulate crop revenues net of farm policy and crop insurance costs. Certainty equivalent analysis is used to rank farm policy and crop insurance alternatives for varying levels of risk aversion.
    Keywords: farm management, risk management, Farm Management, Risk and Uncertainty,
    Date: 2013
  17. By: Eric T. Swanson
    Abstract: A flexible labor margin allows households to absorb shocks to asset values with changes in hours worked as well as changes in consumption. This ability to absorb shocks along both margins can greatly alter the household’s attitudes toward risk, as shown in Swanson (2012). The present paper analyzes how frictional labor markets affect that analysis. Risk aversion is higher: 1) in recessions, 2) in countries with more frictional labor markets, and 3) for households that have more difficulty finding a job. These predictions are consistent with empirical evidence from a variety of sources. Traditional, fixed-labor measures of risk aversion show no stable relationship to the equity premium in a standard real business cycle model with search frictions, while the closed-form expressions derived in the present paper match the equity premium closely.
    Date: 2013
  18. By: Gary Biglaiser (University of North Carolina, Department of Economics); Jacques CreÌmer (Toulouse School of Economics); AndreÌ Veiga (Toulouse School of Economics)
    Abstract: We develop a model of dynamic platform formation under positive platform externalities. Users can switch between an incumbent and entrant platforms, switching opportunities arise stochastically and users can choose whether to accept or reject an opportunity to switch. For homogeneous users, we characterize the incumbency advantage implied by a given equilibrium realization of the switching process. For linear utility, incumbency advantage increases in the mean and dispersion of the incumbent’s share during the switching process, which captures the momentum and coordination of the process. Heterogeneity in preferences may lead some users to delay their switching or never switch at all. Assuming that switching opportunities arrive according to a Poisson process, users switch to the entrant platform if the average preference favors the entrant and if preferences are not too polarized.
    Keywords: platform Formation, Migration, Standardization and Compatibility, Industry Dynamics
    JEL: D85 L14 R23 L15 L16
    Date: 2013–09
  19. By: Robert William, Vivian
    Abstract: Nicolas Bernoulli suggested the St Petersburg game, nearly 300 years ago, which is widely believed to produce a paradox in decision theory. This belief stems from a long standing mathematical error in the original calculation of the expected value of the game. This article argues that, in addition to the mathematical error, there are also methodological considerations which gave rise to the paradox. This article explains these considerations and why because of the modern computer, the same considerations, when correctly applied, also demonstrate that no paradox exists. Because of the longstanding belief that a paradox exists it is unlikely the mere mathematical correction will end the myth. The article explains why it is the methodological correction which will dispel the myth.
    Keywords: Central Limit Theorem, deductive logic, inductive logic, Law of Large Numbers, simulation of games; economic paradoxes; St Petersburg game; St Petersburg Paradox
    JEL: C44 C9 D81 N00
    Date: 2013–09
  20. By: Sandmo, Agnar (Dept. of Economics, Norwegian School of Economics and Business Administration)
    Abstract: The paper considers the history of theories of income distribution, from the time of Adam Smith until the 1970s. It is divided into two main parts. Part I considers the positive theory of income distribution, beginning with the classical economists’ analysis of the functional distribution of income between wages, profits and rent. It goes on to present the new theories that emerged with the marginalist revolution and which were based on maximizing behaviour and market equilibrium. The main focus during the early stages of the new developments was on the markets for consumer goods and the role of marginal utility in price determination. The later neoclassical economists, including Alfred Marshall and Knut Wicksell, paid more attention to the special features that characterized the labour market and the role of marginal productivity in wage formation. In the 20th century the neoclassical theory was extended to include analysis of the role of imperfect competition, human capital and risk-taking. Also included in this part of the paper is a discussion of statistical and institutional approaches. Part II covers normative theories of income distribution and their implications for redistributive policy. It begins with a consideration of the value judgements implicit in the policy recommendations of the classical economists and continues with the attempts to establish an analytical foundation for welfare economics. The rise of Paretian welfare theory with its emphasis on the impossibility of interpersonal comparisons of utility made it difficult to draw conclusions regarding income redistribution, but the older utilitarian approach, including equal sacrifice theories, continued to live on in the modern analysis of optimal redistribution. A short Part III contains some concluding reflections on the position of income distribution theory within economics as a whole.
    Keywords: Functional and personal income distribution; distributive justice; redistribution policy.
    JEL: B10 B20 D30 D63
    Date: 2013–09–27
  21. By: Lintunen , Jussi (Finnish Forest Research Institute); Vilmi, Lauri (Bank of Finland, Monetary Policy and Research Department)
    Abstract: This paper studies the cyclical properties of optimal emission taxes and emissions using a real business cycle model with a stock pollutant. We derive conditions for the procyclicality of optimal emission tax and show that the tax is in typical conditions procyclical. The possibility of a countercyclical behavior of the emission tax increases if 1) the pollution is short-lived and the emission transfer into environmental damages rapidly 2) emissions are countercyclical, 3) marginal damages are strongly increasing and 4), in disutility case, the marginal utility of consumption increases with the increase in the intensity of the harmful environmental process. In the climate change context we show that the optimal carbon tax is procyclical irrespectively on the production technology. Instead, the technology is a key determinant of the cyclicality of the emissions. The optimal carbon tax correlates almost fully with the consumption and as a rule-of thumb, it could be indexed to the consumption level of the economy. The relative scale of tax deviations relative to the consumption deviations is determined by the inverse of the intertemporal elasticity of substitution. Comparison between the optimal emission tax and an optimally set constant emission tax shows that the constant tax leads to very slightly higher emissions but the general economic effects are next to negligible.
    Keywords: optimal emission tax; cyclical properties
    JEL: E32 Q54 Q58
    Date: 2013–10–09

This nep-upt issue is ©2013 by Alexander Harin. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.