nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2014‒05‒17
ten papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Is There a Development Gap in Rationality? By Cappelen, Alexander W.; Kariv, Shachar; Sørensen, Erik Ø.; Tungodden, Bertil
  2. Models as usual for Unusual Risks? On the value of Catastrophic Climate Change By Bruno Lanz
  3. Crisp Fair Gambles By Eric André
  4. A DSGE Model with loss aversion in consumption and leisure: An explanation for business cycles aymmetries By Wilman Gomez
  5. The Life Cycle Model with Recursive Utility: New insights on pension and life insurance contracts By Aase, Knut K.
  6. Money flexibility, price elasticity, and elasticity of marginal utility of consumption By Malakhov, Sergey
  7. A remark on smooth solutions to a stochastic control problem with a power terminal cost function and stochastic volatilities By Yal\c{c}in Aktar; Erik Taflin
  8. Optimal investment under behavioural criteria -- a dual approach By Mikl\'os R\'asonyi; Jos\'e G. Rodr\'iguez-Villarreal
  9. The Market in Economics: Behavioural Assumptions and Value Judgments. By Sandmo, Agnar
  10. Social preferences in the online laboratory: a randomized experiment By Jérôme Hergueux; Nicolas Jacquemet

  1. By: Cappelen, Alexander W. (Dept. of Economics, Norwegian School of Economics and Business Administration); Kariv, Shachar (University of California, Berkeley); Sørensen, Erik Ø. (Dept. of Economics, Norwegian School of Economics and Business Administration); Tungodden, Bertil (Dept. of Economics, Norwegian School of Economics and Business Administration)
    Abstract: We report an experimental test of the four touchstones of rationality in choice under risk – utility maximization, stochastic dominance, expected-utility maximization and small-stakes risk neutrality – with students from one of the best universities in the United States and one of the best universities in Africa, the University of Dar es Salaam. Although the US and the Tanzanian subjects come from different backgrounds and face different economic prospects, they are united by being among the most able in their societies. Importantly, many of whom will exercise an outsized influence over economic and political affairs. We find very small or no significant differences between the two samples in the degree of rationality according to a number of standard economic measures. An alternative approach is to take cognitive ability (IQ) as a proxy for economic rationality. We show that a canonical IQ test indicates a much larger development gap in rationality relative to our economic tests.
    Keywords: Development; rationality; revealed preference; stochastic dominance; expected utility; risk aversion; cognitive ability; experiment.
    JEL: D01 D03 D81 O12
    Date: 2014–01–28
  2. By: Bruno Lanz (The Centre for International Environmental Studies, The Graduate Institute of International and Development Studies, Geneva)
    Abstract: We study the role of alternative intertemporal preference representations in a model of economic growth, stock pollutant and endogenous risk of catastrophic collapse. We contrast the traditional “discounted utility” model, which assumes risk neutrality with respect to intertemporal utility, with a multiplicative choice model that displays risk aversion in that dimension. First, we show that both representations of preferences can rationalize the same “business as usual” economy for a given interest rate and no pollution externality. Second, once we introduce a collapse risk whose hazard rate is a function of the pollution stock, multiplicative preferences recommend a much more stringent policy response. An illustration in the context of climate change indicates that switching to the multiplicative preference representation has a similar effect, in terms of policy recommendations, as scaling up the schedule of the hazard rate by a factor of 100.
    Keywords: Environme ntal policy; Climate change; Catastrophic risks; Risk aversion; Discounting.
    JEL: D63 D81 D99 Q53 Q54
    Date: 2013–11–01
  3. By: Eric André (AMSE - Aix-Marseille School of Economics - Centre national de la recherche scientifique (CNRS) - École des Hautes Études en Sciences Sociales (EHESS) - Ecole Centrale Marseille (ECM))
    Abstract: Axiomatic models of decision under ambiguity with a non-unique prior allow for the existence of Crisp Fair Gambles: acts whose expected utility is nul whichever of the priors is used. But, in these models, the DM has to be indifferent to the addition of such acts. Their existence is then at odds with a preference taking into account the variance of the prospects. In this paper we study some geometrical and topological properties of the set of priors that would rule out the existence of Crisp Fair Gambles, properties which have consequences on what can be an unambiguous financial asset.
    Keywords: monotone mean-variance preferences; ambiguity; set of priors; crisp acts; unambiguous asset
    Date: 2014–03
  4. By: Wilman Gomez
    Abstract: Abstract: In this paper, an asymmetric DSGE model is built in order to account for asymmetries in business cycles. One of the most important contributions of this work is the construcion of a general utility function which nests loss aversion, risk aversion and habits formation, by means of a smooth transition function. The main idea behind this asymmetric utility funcion is that under a recession, the agents over-smooth consumption and leisure choices in order to avoid a huge departure of them from the reference level of the utility; while under a boom, the agents simply smooth consumption and leisure but trying to be as far as possible from the reference level of utility. The simulations of this model by means of Perturbations Method show that it is possible to reproduce asymmetrical business cycles where recession (on shock) are stronger than booms and booms are more long lasting than recession. One additional and unexpected result is a downward stickyness shown by real wages and as consequence of this, a more persistente fall in employment in recession than in boom. Thus the model reproduces not only asymmetrical business cycles but also real stickyness and hysteresis.
    Date: 2014–04–01
  5. By: Aase, Knut K. (Dept. of Business and Management Science, Norwegian School of Economics)
    Abstract: For the conventional model with additive and separable expected utility, risk aversion and intertemporal elasticity of substitution in consumption sometimes play conflicting roles, in particular in life insurance and pensions. We propose to use recursive utility in the life cycle model, where we use the stochastic maximum principle to find the optimal solutions. This is a robust method which, among other things, do not require the Markov property. Optimal pension and life insurance contracts with these preferences involve consumption smoothing, not present in similar contracts using the conventional model. The model explains why aggregate consumption in society can be as smooth as implied by data, and at the same time be consistent with the relatively large, observed growth rate. Our analysis can also explain the prevalence of the two most common pension plans, defined benefit and defined contribution.
    Keywords: The life cycle model; recursive utility; optimal pension insurance; optimal life insurance; defined benefit; defined contribution; equity premium puzzle; the stochastic maximum principle
    JEL: D91
    Date: 2014–05–14
  6. By: Malakhov, Sergey
    Abstract: The development of G.Stigler’s original model of search describes the mathematical relationship between the elasticity of the marginal utility of consumption, the price elasticity, and the elasticity of the marginal utility of money income with respect to increase in the price of living and/or to inflation. This relationship can be used not only in economics of well-being but also in microeconomics where the increase in the price of living, i.e., in purchase price, can make consumption “bad” under the Veblen effect.
    Keywords: money flexibility, price elasticity, elasticity of marginal utility of consumption, Veblen effect
    JEL: D11 D63
    Date: 2014–05–13
  7. By: Yal\c{c}in Aktar; Erik Taflin
    Abstract: Incomplete financial markets are considered, defined by a multi-dimensional non-homogeneous diffusion process, being the direct sum of an It\^{o} process (the price process), and another non-homogeneous diffusion process (the exogenous process, representing exogenous stochastic sources). The drift and the diffusion matrix of the price process are functions of the time, the price process itself and the exogenous process. In the context of such markets and for power utility functions, it is proved that the stochastic control problem consisting of optimizing the expected utility of the terminal wealth, has a classical solution (i.e. $C^{1,2}$). This result paves the way to a study of the optimal portfolio problem in incomplete forward variance stochastic volatility models, along the lines of Ref: Ekeland et al.
    Date: 2014–05
  8. By: Mikl\'os R\'asonyi; Jos\'e G. Rodr\'iguez-Villarreal
    Abstract: We consider a discrete-time, generically incomplete market model and a behavioural investor with power-like utility and distortion functions. The existence of optimal strategies in this setting has been shown in a previous paper under certain conditions on the parameters of these power functions. In the present paper we prove the existence of optimal strategies under a different set of conditions on the parameters, identical to the ones which were shown to be necessary and sufficient in the Black-Scholes model. Although there exists no natural dual problem for optimisation under behavioural criteria (due to the lack of concavity), we will rely on techniques based on the usual duality between attainable contingent claims and equivalent martingale measures.
    Date: 2014–05
  9. By: Sandmo, Agnar (Dept. of Economics, Norwegian School of Economics and Business Administration)
    Abstract: This paper tries to convey the essence of the economic theory of behaviour of individuals and firms to an audience of non-economists. The hypotheses of utility and profit maximization and their use as building blocks in the theory of market equilibrium are explained. The paper discusses the efficiency of the market mechanism and sources of market failure. It considers the origin of preferences and the role played by ethical and religious views for consumer demand and labour supply. It concludes by discussing the role of economic theory in the design of institutions and considers the view that the introduction of market incentives in new areas may be harmful to society.
    Keywords: Utility and profit maximization; incentives; welfare.
    JEL: A13 B40 D01
    Date: 2014–04–22
  10. By: Jérôme Hergueux (IEP Paris - Sciences Po Paris - Institut d'études politiques de Paris - Institut d'Études Politiques [IEP] - Paris - PRES Sorbonne Paris Cité - Fondation Nationale des Sciences Politiques [FNSP]); 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)
    Abstract: Internet is a very attractive technology for the implementation of experiments, both in order to obtain larger and more diverse 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 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 control the assignment of subjects between the Internet and a traditional university laboratory. We apply the comparison to the elicitation of social preferences in a Public Good game, a dictator game, an ultimatum bargaining game and a trust game, coupled with an elicitation of risk aversion. This comparison concludes in favor of the reliability of behaviors elicited through the Internet. We moreover find a strong overall parallelism in the preferences elicited in the two settings. The paper also reports some quantitative differences in the point estimates, which always go in the direction of more other-regarding decisions from online subjects. This observation challenges either the predictions of social distance theory or the generally assumed increased social distance in internet interactions.
    Keywords: Social experiment ; Field experiment ; Internet Methodology ; Randomized assignment
    Date: 2014

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