nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2014‒11‒07
thirteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Temporal Resolution of Uncertainty and Recursive Models of Ambiguity Aversion By Strzalecki, Tomasz
  2. How Much Would You Pay to Resolve Long-Run Risk? By Epstein, Larry G.; Farhi, Emmanuel; Strzalecki, Tomasz
  3. Is Self-Reported Risk Aversion Time Variant? By Seeun Jung; Carole Treibich
  4. Hedging under an expected loss constraint with small transaction costs By Bruno Bouchard; Ludovic Moreau; Mete Soner
  5. Higher-order Risk Preferences in Social Settings - An Experimental Analysis By Timo Heinrich; Thomas Mayrhofer
  6. Utility functions, fiscal shocks and the open economy - In the search of a positive consumption multiplier By Philipp Wegmueller
  7. Doing it now or later with payoff externalities: Experimental evidence on social time preferences By Giovanni Ponti; Ismael Rodríguez Lara; Daniela Di Cagno
  8. K-state switching models with time-varying transition distributions – Does credit growth signal stronger effects of variables on inflation? By Sylvia Kaufmann
  9. An approximate dual-self model and paradoxes of choice under risk By Fudenberg, Drew; Levine, David K.; Maniadis, Zacharias
  10. Tax Compliance Social Norms and Institutional Quality: An Evolutionary Theory of Public Good Provision By Panayiotis Nicolaides
  11. Behavioral Economics of Crime Rates and Punishment Levels By Saori Chiba; Kaiwen Leong
  12. Decision Errors, Legal Uncertainty and Welfare: a General Treatment By Yannis Katsoulacos; David Ulph
  13. Preference Elicitation under Oath By Nicolas Jacquemet; Robert-Vincent Joule; Stephane Luchini; Jason Shogren

  1. By: Strzalecki, Tomasz
    Abstract: Dynamic models of ambiguity aversion are increasingly popular in applied work. This paper shows that there is a strong interdependence in such models between the ambiguity attitude and the preference for the timing of the resolution of uncertainty, as defined by the classic work of Kreps and Porteus (1978). The modeling choices made in the domain of ambiguity aversion influence the set of modeling choices available in the domain of timing attitudes. The main result is that the only model of ambiguity aversion that exhibits indifference to timing is the maxmin expected utility of Gilboa and Schmeidler (1989). This paper examines the structure of the timing nonindifference implied by the other commonly used models of ambiguity aversion. This paper also characterizes the indifference to long-run risk, a notion introduced by Duffie and Epstein (1992). The interdependence of ambiguity and timing that this paper identifies is of interest both conceptually and practically—especially for economists using these models in applications.
    Date: 2013
  2. By: Epstein, Larry G.; Farhi, Emmanuel; Strzalecki, Tomasz
    Abstract: Though risk aversion and the elasticity of intertemporal substitution have been the subjects of careful scrutiny, 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 thereof 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: 2014
  3. By: Seeun Jung; Carole Treibich (Université de Cergy-Pontoise, THEMA; CNRS & EHESS)
    Abstract: We examine a Japanese Panel Survey in order to check whether self-reported risk aversion varies over time. In most panels, risk attitude variables are collected only once (found in only one survey wave), and it is assumed that self-reported risk aversion reflects the individual's time-invariant component of preferences to- ward risk. Nonetheless, the question could be asked as to whether the financial and macro shocks a person faces over his lifetime modify his risk aversion. Our em- pirical analysis provides evidence that risk aversion is composed of a time-variant part and shows that the variation cannot be ascribed to measurement error or noise given that it is related to income shocks. Taking into account the fact that there are time-variant factors in risk aversion, we investigate how often it is preferable to collect the risk aversion measure in long panel surveys. Our result suggests that the best predictor of current behavior is the average of risk aversion, where risk aversion is collected every two years. It is therefore advisable for risk aversion measures to be collected every two years in long panel surveys.
    Keywords: Risk Aversion; Panel Data
    JEL: C33 D31 J11
    Date: 2014
  4. By: Bruno Bouchard (CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - CNRS : UMR7534 - Université Paris IX - Paris Dauphine, CREST - Centre de Recherche en Économie et Statistique - INSEE - École Nationale de la Statistique et de l'Administration Économique); Ludovic Moreau (Department of Mathematics, ETH zurich - Swiss Federal Institute of Technology in Zurich (ETH Zurich).); Mete Soner (Department of Mathematics, ETH zurich - Swiss Federal Institute of Technology in Zurich (ETH Zurich).)
    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.
    Keywords: Expected loss constraint, hedging, transaction cost, asymptotic expansion.
    Date: 2013–09–19
  5. By: Timo Heinrich; Thomas Mayrhofer
    Abstract: We study higher-order risk preferences, i.e. prudence and temperance, next to risk aversion in social settings. Previous experimental studies have shown that higher-order risk preferences affect the choices of individuals deciding privately on lotteries that only affect their own pay-off. Yet, most risky and financially relevant decisions in the field are made in the social settings of households or organizations. We aim to narrow the gap between laboratory and field evidence by creating a more realistic decision making environment in the laboratory that allows us to identify the influence of different social settings under controlled conditions. We elicit higher-order risk preferences of individuals and systematic ally vary how an individual’s decision is made (alone or while communicating with a partner) and who is affected by the decision (only the individual or the partner as well). In doing so, we can isolate the effects of other-regarding concerns and communication on choices. We observe that individuals become more risk-averse when the partner is able to communicate with the decision maker. However, we do not observe an influence of social settings on prudence and temperance. Our results reveal that the majority of choices are risk-averse, prudent, and temperate across social settings.
    Keywords: Experiment; individual decisions; group decisions; risk aversion; prudence; temperance
    JEL: C91 C92 D70 D81
    Date: 2014–10
  6. By: Philipp Wegmueller
    Abstract: This paper analyzes the dynamic effects of a fiscal policy shock and its transmission mechanism in a small open economy and compares the responses under different specifications of the utility function. The traditional Mundell-Flemming model tells that fiscal policy is more effective under a peg than under a float. This result is not confirmed for a baseline small open economy model with separable preferences. The present paper offers a survey of non-separable utility found in the literature on fiscal policy shocks and compares their implications for the transmission mechanism. The aim is to overturn the negative wealth effect of an increase in government spending, which causes a decrease in private consumption under the baseline separable utility function. Using a plausible calibration of the model, I find that if the complementarity between consumption and hours worked is large enough, then the response of private consumption is likely to be positive, although the assumptions have to be strong. This result holds for any specification of exchange rate regime.
    Keywords: Fiscal Shocks; Non-Separable Utility; Exchange Rate Regimes; Private Consumption
    JEL: E52 E62 F41
    Date: 2014–10
  7. By: Giovanni Ponti (Universidad de Alicante); Ismael Rodríguez Lara (Universidad de Alicante); Daniela Di Cagno (School of Government)
    Abstract: We report experimental evidence on the effects of social preferences on intertemporal decisions. To this aim, we set up an intertemporal Dictator Game and investigate whether (and how) subjects change theirchoices, compared with those they had taken in absence of any payoff externality in a previous stage of the experiment. We run two treatments -INFO and BELIEF, respectively- depending on whether Dictators know -or are asked to elicit- their assigned Recipients' risk and time preferences. We find that high (own) risk aversion is associated with low (own) discounting. We also find that (heterogeneous) socialtime preferences are significant determinants of choices, in that Dictators display a marked propensityto account for the Recipients' intertemporal concerns.
    Keywords: intertemporal decisions, time preferences, social preferences.
    Date: 2014–09
  8. By: Sylvia Kaufmann (Study Center Gerzensee)
    Abstract: Two Bayesian sampling schemes are outlined to estimate a K-state Markov switching model with time-varying transition probabilities. Data augmentation for the multinomial logit model of the transition probabilities is alternatively based on a random utility and a difference in random utility extension. We propose a definition to determine a relevant threshold level of the covariate determining the transition distribution, at which the transition distributions are balanced across states. Identification issues are addressed with random permutation sampling. In terms of efficiency, the extension to the difference in random utility specification in combination with random permutation sampling performs best. We apply the method to estimate a regime dependent two-pillar Phillips curve for the euro area, in which lagged credit growth determines the transition distribution of the states.
    Date: 2014–02
  9. By: Fudenberg, Drew; Levine, David K.; Maniadis, Zacharias
    Abstract: We derive a simplified version of the model of Fudenberg and Levine, 2006 and Fudenberg and Levine, 2011 and show how this approximate model is useful in explaining choice under risk. We show that in the simple case of three outcomes, the model can generate indifference curves that “fan out†in the Marschak–Machina triangle, and thus can explain the well-known Allais and common ratio paradoxes that models such as prospect theory and regret theory are designed to capture. At the same time, our model is consistent with modern macroeconomic theory and evidence and generates predictions across a much wider set of domains than these models.
    Date: 2014
  10. By: Panayiotis Nicolaides
    Abstract: This paper presents an evolutionary theory of public good provision. The framework analyses the relationship between endogenous tax compliance norms, formed by the interactions of rationally-bounded individuals in a network, and the quality of institutions that collect taxes and distribute the public good to the individuals. Conditions for the level of public good utility are derived and illustrated on the "Public Good Provision Hypersurface"; a two-dimensional manifold that describes the relationship between norms, institutional quality and public good provision. I show that the effectiveness of the government to collect taxes increases the determinacy of public good provision but does not ensure its maximisation, which depends also on the level of wasteful government expenditure. If the government is ineffective in performing audits, the welfare from public good provision becomes subject to social norms. Lastly, a condition is derived at which social norms of tax compliance can act as a substitute for enforcement and can result in the maximisation of public good utility.
    Keywords: Taxation; Tax compliance; Social norms Public goods, Government waste
    JEL: H26 H41 C73
    Date: 2014–10
  11. By: Saori Chiba; Kaiwen Leong
    Abstract: Empirical studies have shown, paradoxically, that increasing the probability of apprehension can correlate with an increase in the total number of criminal actions. To examine this phenomenon, this paper develops a theory of "personal rules" based on the tradeoff between oneÕs self-image of criminal productivity and the temptation Ð salience of the present Ð of taking the easy way out by committing a crime. This theory analyzes transformation of lapses into precedents that undermine future self-restraint. The foundation for this transformation is imperfect recall of oneÕs own criminal productivity within certain defined parameters, which leads people to draw inaccurate inferences from their past actions. Rationalization may lead to overestimation of the expected utility of committing a crime when the opportunity presents itself.
    Keywords: Crime, Imperfect Recall,Willpower.
    JEL: D03 D81 K42
    Date: 2014–10
  12. By: Yannis Katsoulacos (Athens University of Economics and Business); David Ulph (University of St Andrews)
    Abstract: This paper provides a general treatment of the implications for welfare of legal uncertainty. We distinguish legal uncertainty from decision errors: though the former can be influenced by the latter, the latter are neither necessary nor sufficient for the existence of legal uncertainty. We show that an increase in decision errors will always reduce welfare. However, for any given level of decision errors, information structures involving more legal uncertainty can improve welfare. This holds always, even when there is complete legal uncertainty, when sanctions on socially harmful actions are set at their optimal level. This transforms radically one’s perception about the “costs” of legal uncertainty. We also provide general proofs for two results, previously established under restrictive assumptions. The first is that Effects-Based enforcement procedures may welfare dominate Per Se (or object-based) procedures and will always do so when sanctions are optimally set. The second is that optimal sanctions may well be higher under enforcement procedures involving more legal uncertainty.
    Keywords: optimal law enforcement, optimal penalties, legal uncertainty, decision errors
    JEL: K4 L4 K21 K23
    Date: 2014–02–01
  13. By: Nicolas Jacquemet (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris); Robert-Vincent Joule (LPS-AIX - Laboratoire de Psychologie Sociale - Université de Provence - Aix-Marseille I : EA849); Stephane Luchini (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - CNRS : UMR7316); Jason Shogren (Departement of Economics and Finance, University of Wyoming - University of Wyoming)
    Abstract: Eliciting sincere preferences for non-market goods remain a challenge due to the discrepency between hypothetical and real behavior and false zeros. The gap arises because people either overstate hypothetical values or understate real commitments or a combination of both. Herein we examine whether the traditional real-world institution of the solemn oath can improve preference elicitation. Applying the social psychology theory on the oath as a truth-telling-commitment device, we ask our bidders to swear on their honour to give honest answers prior to participating in an incentive-compatible second-price auction. The oath is an ancillary mechanism to commit bidders to bid sincerely in a second-price auction. Results from our induced valuation testbed treatments suggest that the oath-only auctions outperform all our other auctions (real and hypothetical). In our homegrown valuation treatments eliciting preferences for dolphin protection, the oath-only design induced people to treat as binding both their experimental budget constraint (i.e., lower values on the high end of the value distribution) and participation constraint (i.e., positive values in place of the zero bids used to opt-out of auction). Based on companion treatments, we show the oath works through an increase in the willingness to tell the truth, due to a strengthening of the intrinsic motivation to do so.
    Keywords: Oath; Commitment; Vickrey auction; Hypothetical bias; Induced values; Homegrown values
    Date: 2013–01

This nep-upt issue is ©2014 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.