nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2015‒01‒26
23 papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Using Prospect Theory to Explain Anomalous Crop Insurance Coverage Choice By Babcock, Bruce
  2. The Impact of Farmers’ Risk Preferences on the Design of an Individual Yield Crop Insurance By Bougherara, Douadia; Piet, Laurent
  3. Non-concave utility maximisation on the positive real axis in discrete time By Laurence Carassus; Mikl\'os R\'asonyi; Andrea M. Rodrigues
  4. Information, Random Regret Minimisation, Random Utility Maximisation: Willingness to pay for Renewable Energy By Longo, Alberto; Boeri, Marco
  5. Time Preferences and Risk Aversion: Tests on Domain Differences By Ioannou , Christos A.; Sadeh, Jana
  6. Consumption investment optimization with Epstein-Zin utility in incomplete markets By Hao Xing
  7. Optimality in a Stochastic OLG Model with Ambiguity By Eisei Ohtaki; Hiroyuki Ozaki
  8. Risk Aversion among Smallholder High-value Crop Farmers in the Southern Philippines By Domingo, Sonny N.; Parton, Kevin A.; Mullen, John; Jones, Randall
  9. The Timing and Probability of Switching to Second-line Regimen - An application to Second-Line Antiretroviral Therapy in India. By Felipa, de Mello-Sampayo
  10. Analysing impacts of changing price variability with estimated farm risk-programming models By Jansson, Torbjörn; Heckelei, Thomas; Gocht, Alexander; Basnet, Shyam Kumar; Zhang, Yinan; Neuenfeldt, Sebastian
  11. Modelling the Participation Decision in Agri-Environmental Schemes By Murphy, Geraldine; O’Donoghue, Cathal; Hynes, Stephen; Murphy, Eithne
  12. Regulating the Environmental Consequences of Preferences for Social Status within an Evolutionary Framework By Eftichios Sartzetakis; Anastasios Xepapadeas; Athanasios Yannacopoulos
  13. Equilibrium with Mutual Organizations in Adverse Selection Economies By Prescott, Edward C.; Blandin, Adam; Boyd, John H.
  14. Global Sunspots and Asset Prices in a Monetary Economy By Roger E.A. Farmer
  15. Choice, Deferral and Consistency By Miguel Costa-Gomes; Carlos Cueva; Georgios Gerasimou
  16. The Hidden Cost of Regulation: Emotional Responses to Command and Control By Just, David; Hanks, Andrew
  17. An envelope approach to tournament design By Christian Ewerhart
  18. Adaptation vs. climate protection: Responses to climate change and policy preferences of individuals in China, Germany, and the USA By Claudia Schwirplies
  19. An Experimental Study of Money Illusion in Intertemporal Decision Making By Tetsuo Yamamori Author-Name: Kazuyuki Iwata; Akira Ogawa
  20. Are ranking preferences information methods comparable with the choice experiment information in predicting actual behavior? By Yangui, Ahmed1; Akaichi, Faiçal; Costa-Font, Montserrat; Gil, Jose Maria
  21. Loan loss provisioning and procyclicality: Evidence from an expected loss model By Domikowsky, Christian; Bornemann, Sven; Duellmann, Klaus; Pfingsten, Andreas
  22. Combined Density Nowcasting in an uncertain economic environment By Knut Are Aastveit; Francesco Ravazzolo; Herman K. van Dijk
  23. Inflation Uncertainty and Disagreement in Bond Risk Premia By D'Amico, Stefania; Orphanides, Athanasios

  1. By: Babcock, Bruce
    Abstract: Farmers’ decisions about how much crop insurance to buy are not generally consistent with either expected profit or utility maximization. They do not pick coverage levels that maximize expected subsidy nor do they demand full insurance coverage. In addition, the absolute size of farmer-­‐paid premium seems to influence the type of insurance product farmers buy. Understanding demand drivers for crop insurance has taken on new importance because of the expanded role Congress has designated for crop insurance as a key part of Federal farm policy. By modeling financial outcomes as gains and losses, prospect theory offers an appropriate framework to better understand farmers’ purchase decisions. Because insured events are best modeled as continuous random variables, cumulative prospect theory is used to find a theoretical foundation that can explain farmers’ anomalous decisions. The role of the reference point that defines outcomes as either a gain or a loss, the degree of loss aversion, and the probability weighting function are explored under typical distributions of price, yield, and revenue for a corn producer. Choice of reference points that are consistent with farmers using crop insurance to manage risk are not consistent with observed purchase decisions. Choosing the reference point to make crop insurance akin to a stand alone investment generates optimal choices that are consistent with observed decisions and with the way that insurance agents sell the product.
    Keywords: Agribusiness, Agricultural Finance,
    Date: 2015
  2. By: Bougherara, Douadia; Piet, Laurent
    Abstract: Kahneman and Tversky’s Cumulative Prospect Theory (CPT) has proved to be better suited for representing risk preferences than von Neumann and Morgenstern’s Expected Utility Theory (EUT). We argue that neglecting this may explain to some extent why farmers do not contract crop insurance as much as they are expected to. We model the decision to contract an individual yield crop insurance for a sample of 186 French farmers. We show that 21% of the farmers who would be expected to contract assuming that their preferences are EUT, would actually not do so if their true preferences are in fact CPT.
    Keywords: Yield, Crop Insurance, Cumulative Prospect Theory, Premium subsidy, France, Risk and Uncertainty,
    Date: 2014–08
  3. By: Laurence Carassus; Mikl\'os R\'asonyi; Andrea M. Rodrigues
    Abstract: We treat a discrete-time asset allocation problem in an arbitrage-free, generically incomplete financial market, where the investor has a possibly non-concave utility function and wealth is restricted to remain non-negative. Under easily verifiable conditions, we establish the existence of optimal portfolios.
    Date: 2015–01
  4. By: Longo, Alberto; Boeri, Marco
    Abstract: We investigate how different levels of information affect respondents’ preferences as well as choice behaviour in choice experiments by analysing respondents’ choices using two choice paradigms: the Random Utility Maximisation (RUM) and the Random Regret Minimization (RRM). The RRM offers a tractable, regret-based model complementary to the dominant RUM. Analysing choice related to hypothetical programmes for the promotion of renewable energy, we find that varying the level of information does not affect preferences and scale, whilst it does affect the choice paradigm. Additional information increases the probability that a respondent’s choices are better explained by the RUM than the RRM.
    Keywords: Random Regret Minimization, Random Utility Maximisation, renewable energy, energy security, greenhouse gases emissions, Consumer/Household Economics, Resource /Energy Economics and Policy,
    Date: 2014–08
  5. By: Ioannou , Christos A.; Sadeh, Jana
    Abstract: The design and evaluation of environmental policy requires the incorporation of time and risk elements as many environmental outcomes extend over long time periods and involve a large degree of uncertainty. Understanding how individuals discount and evaluate risks with respect to environmental outcomes is a prime component in designing effective environmental policy to address issues of environmental sustainability, such as climate change. Our objective in this study is to investigate whether subjects' time preferences and risk aversion across the monetary domain and the environmental domain differ. Crucially, our experimental design is incentivized: in the monetary domain, time preferences and risk aversion are elicited with real monetary payoffs, whereas in the environmental domain, we elicit time preferences and risk aversion using real (bee-friendly) plants. We find that subjects' time preferences are not significantly different across the monetary and environmental domains. In contrast, subjects' risk aversion is significantly different across the two domains. More specifically, subjects (men and women) exhibit a higher degree of risk aversion in the environmental domain relative to the monetary domain. Finally, we corroborate earlier results, which document that women are more risk averse than men in the monetary domain. We show this finding to, also, hold in the environmental domain.
    Date: 2014–12–28
  6. By: Hao Xing
    Abstract: In a market with stochastic investment opportunities, we study an optimal consumption investment problem for an agent with recursive utility of Epstein-Zin type. Focusing on the empirically relevant specification where both the risk aversion and the elasticity of intertemporal substitution are in excess of one, we characterize optimal consumption and investment strategies via backward stochastic differential equations. The state price density is also obtained, confirming a conjecture in Schroder and Skiadas, J. Econ. Theory, 89, 68--126, 1999, and meeting demands from applications where Epstein-Zin utilities were used to resolve several asset pricing puzzles. The empirically relevant utility specification introduces difficulties to the optimization problem due to the fact that the Epstein-Zin aggregator is neither Lipschitz nor jointly concave in all its variables.
    Date: 2015–01
  7. By: Eisei Ohtaki; Hiroyuki Ozaki
    Abstract: It has been known that, in the overlapping generations (OLG) model with the complete market, we can judge optimality of an equilibrium allocation by examining the associated equilibrium price. This article reexamine this observation in a stochastic OLG model with the maxmin expected utility preference. It is shown that, under such preferences, optimality of an equilibrium allocation depends on the set of possible supporting prices, not necessarily on the associated equilibrium price itself. Therefore, observations of an equilibrium price does not necessarily tell us optimality of the equilibrium allocation.
  8. By: Domingo, Sonny N.; Parton, Kevin A.; Mullen, John; Jones, Randall
    Abstract: Several elicitation techniques were employed to gauge the attitudes to risk of smallholder high-value crop farmers in the southern Philippines. Results showed varying degrees of risk aversion, neutrality, and preference among smallholder farmers. Although some of the techniques classified distinct groups of local growers as either risk-averse or risk-preferring, the estimated risk aversion coefficients were relatively low signifying an inclination toward risk neutrality. These may partly explain the degree of openness or non-openness of smallholder farmers to cultural changes and development interventions. Variations in farmers` risk attitude classification among the different elicitation methods indicate the need for further validation studies and more definitive evaluation standards.
    Keywords: Philippines, risk attitude elicitation, farmers` risk aversion, smallholder high-value crop farming
    Date: 2015
  9. By: Felipa, de Mello-Sampayo
    Abstract: Health fluctuations render the outcome of any treatment switch uncertain, so that decision makers might have to wait for more information before optimally switching treatments. This paper sets up a stochastic model that provides an optimal rule for the timing of treatment switch. The results of the model were then tested empirically with patient-based data on first-line and second-line antiretroviral treatment in India. The empirical results support the findings of the analytical model.
    Keywords: Uncertainty; Utility Function; Health; Antiretroviral Treatment; Treatment Switch
    JEL: C61 D81 I18
    Date: 2014–12–29
  10. By: Jansson, Torbjörn; Heckelei, Thomas; Gocht, Alexander; Basnet, Shyam Kumar; Zhang, Yinan; Neuenfeldt, Sebastian
    Abstract: We formulate and estimate a farm level simulation model of agricultural crop production, and apply it to a scenario with increasing yield variability. The objective function is of the mean-variance utility type with a positive mathematical programming (PMP) cost function, and it is estimated using the optimality conditions and a large panel data set obtained from the FADN. Special attention is given to the problem of separating the effect of the covariance matrix from that of the quadratic PMP terms. The model is applied in a partial analysis of impacts of climate change in Germany by exogenously changing yield patterns.
    Keywords: Climate change, positive mathematical programming, risk, Bayesian econometrics, FADN, Research Methods/ Statistical Methods, Risk and Uncertainty,
    Date: 2014–08
  11. By: Murphy, Geraldine; O’Donoghue, Cathal; Hynes, Stephen; Murphy, Eithne
    Abstract: Understanding what influences farmers’ decisions to participate in a voluntary agri-environmental scheme(AES) is essential for gauging scheme success. The Rural Environment Protection Scheme (REPS) was a voluntary AES that was available to all Irish farmers from 1994 to 2009. This paper models the participation decision of Irish farmers in REPS using a 15-year panel dataset. The approach taken is novel: actual values for gross outputs, direct costs and working hours are compared to simulated counterfactual values using a conditional logit framework. Model results show that Irish farmers behave rationally by maximising utility from both consumption and leisure but that their preferences differ by region and over time. In addition, the participation functions of viable and non-viable farmers are dissimilar in a number of ways. Policy makers may therefore need to target both groups of farmers using separate schemes in the future.
    Keywords: Agri-Environmental Schemes, Choice Modelling, Environmental Economics and Policy, Research Methods/ Statistical Methods,
    Date: 2014–08
  12. By: Eftichios Sartzetakis; Anastasios Xepapadeas; Athanasios Yannacopoulos
    Abstract: Taking as given that we are consuming too much and that overconsumption leads to environmental degradation, the present paper examines the regulator's choices between informative advertisement and consumptiontaxation. We model overconsumption by considering individuals that care about social status apart from the intrinsic utility, derived from direct consumption. We assume that there also exist individuals that care only about their own private consumption and we examine the evolution of preferences through time by allowing individuals to alter their behavior as a result of a learning process, akin to a replicator dynamics type.We consider the regulator's choice of consumption taxation and informative advertisement both in an arbitrary and an optimal control context. In the arbitrary overconsumption control context we find that the regulator could decrease, or even eliminate, the share of status seekers in the population. In the context of optimal overconsumption control, we show that the highest welfare is attained when status seekers are completely eliminated, while the lowest in the case that the entire population consists of status seekers.
    Keywords: status-seaking, replicator dynamics, information provision, environmental taxation
    JEL: Q53 Q58 D62 D82
    Date: 2015–01–19
  13. By: Prescott, Edward C. (Federal Reserve Bank of Minneapolis); Blandin, Adam (Arizona State University); Boyd, John H. (University of Minnesota)
    Abstract: An equilibrium concept in the Debreu (1954) theory-of-value tradition is developed for a class of adverse selection economies and applied to the Spence signaling and Rothschild-Stiglitz (1976) adverse selection environments. The equilibrium exists and is optimal. Further, all equilibria have the same individual type utility vector. The economies are large with a finite number of types that maximize expected utility on an underlying commodity space. An implication of the analysis is that the invisible hand works for this class of adverse selection economies.
    Keywords: adverse selection equilibrium; theory of value; insurance; signaling; mutual organization; the core
    JEL: C62 D46 D82 G22 G29
    Date: 2015–01–09
  14. By: Roger E.A. Farmer
    Abstract: The representative agent (RA) model, widely used by macroeconomists, successfully explains the co-movements among consumption, investment, employment and GDP. It is much less successful at explaining asset price data. Here, I construct a simple heterogeneous agent model, driven by sunspots, that provides a bridge between macroeconomics and finance theory. Most existing sunspot models use local linear approximations: instead, I construct global sunspot equilibria. My agents are expected utility maximizers with logarithmic utility functions, there are no fundamental shocks and markets are sequentially complete. Despite the simplicity of these assumptions, I am able to go a considerable way towards explaining features of asset pricing data that have presented an obstacle to previous models that adopted similar assumptions. My model generates volatile persistent swings in asset prices, a substantial term premium for long bonds and bursts of conditional volatility in rates of return. If my explanation for asset price volatility is accepted, models that build on my framework have the potential to unify macroeconomics with finance theory in a simple and parsimonious way.
    JEL: E3 E43 G12
    Date: 2015–01
  15. By: Miguel Costa-Gomes; Carlos Cueva; Georgios Gerasimou
    Abstract: In this paper we study decision making in situations where the individual's preferences are not assumed to be complete. First, we identify conditions that are necessary and sufficient for choice behavior in general domains to be consistent with maximization of a possibly incomplete preference relation. In this model of maximally dominant choice, the agent defers/avoids choosing at those and only those menus where a most preferred option does not exist. This allows for simple explanations of conflict-induced deferral and choice overload. It also suggests a criterion for distinguishing between indifference and incomparability based on observable data. A simple extension of this model also incorporates decision costs and provides a theoretical framework that is compatible with the experimental design that we propose to elicit possibly incomplete preferences in the lab. The design builds on the introduction of monetary costs that induce choice of a most preferred feasible option if one exists and deferral otherwise. Based on this design we found evidence suggesting that a quarter of the subjects in our study had incomplete preferences, and that these made significantly more consistent choices than a group of subjects who were forced to choose. The latter effect, however, is mitigated once data on indifferences are accounted for.
    Keywords: Incomplete preferences; choice deferral; indecisiveness; preference elicitation; choice consistency
    JEL: C91 D01 D03 D11 D12
    Date: 2014–12–12
  16. By: Just, David; Hanks, Andrew
    Abstract: In economic models of behavior consumers are assumed to value the goods and services they purchase based on stable preferences over externally identifiable attributes such as quality. These models predict that consumers will respond to changes in price in a way that is independent of the source of the price change. Yet research in the behavioral sciences indicates that consumers that are emotionally attached to a consumption good or other behavior might respond with resistance when policies threaten their consumption or behavior. Moreover, policies that in fact validate some emotional attachments can stir a stronger preference for the good or behavior. Reviewing both survey and experimental data from the literature, we demonstrate how such emotional responses can create hidden costs to policy implementation that could not be detected using standard welfare economic techniques. Building upon Rabin’s work on fairness in games, we propose a partial equilibrium model of emotional response to policy whereby preferences are endogenous to policy choices. In accordance with evidence both from our own analysis and the field, we propose that confrontational policies (such as a sin tax) increase the marginal utility for a good, and that validating policies (such as a subsidy) also increases the marginal utility for a good. A social planner that ignores potential emotional responses to policy changes may unwittingly induce significant dead weight loss. Using our model, we propose a feasible method to determine if emotional deadweight costs exist, and to place a lower bound on the size of these costs.
    Keywords: Political Economy, Production Economics, Public Economics,
    Date: 2015
  17. By: Christian Ewerhart
    Abstract: Optimal rank-order tournaments have traditionally been studied using a first-order approach. The present analysis relies instead on the construction of an "upper envelope" over all incentive compatibility conditions. lt turns out that the first-order approach is not innocuous. For example, in contrast to the traditional understanding, tournaments may be dominated by piece rates even if workers are risk-neutral. The paper also offers a strikingly simple characterization of the optimal tournament for quadratic costs and CARA utility, as well as an extension to large tournaments.
    Keywords: Rank-order tournaments, first-order approach, envelope theorem
    JEL: C62 D86 L23
    Date: 2014–12
  18. By: Claudia Schwirplies (University of Kassel)
    Abstract: This paper investigates the interrelation between adaptation and climate protection efforts of individuals in a cross-country comparison. The theoretical predictions based on a subjective utility framework demonstrate that, at the individual level, private adaptation and climate protection activities are determined by different factors and thus cannot be substitutes. Considering seven climate protection and four adaptation measures, these theoretical predictions are tested empirically using representative data from more than 3400 citizens in China, Germany, and the USA. The empirical findings are consistent with the theoretical predictions that the engagement in adaptation and climate protection activities tends to be positively related. While climate protection efforts seem to be mainly driven by their benefits (e.g., financial advantages or feelings of warm glow), adaptation activities are significantly influenced by a higher income and the individual evaluation of the risk that negative consequences from climate change occur. There is also some evidence that a perceived lack of public engagement in climate protection is compensated by increased private adaptation and climate protection efforts. Preferences for public adaptation and climate protection are significantly determined by individuals’ beliefs about the efforts of others, social norms, feelings of warm glow, and confidence in the effectiveness.
    Keywords: Adaptation, climate protection, climate change, policy preferences
    JEL: H41 Q54 Q58
    Date: 2015
  19. By: Tetsuo Yamamori Author-Name: Kazuyuki Iwata; Akira Ogawa
    Abstract: To examine the degree to which price fluctuations affect how individuals approach an intertemporal decision-making problem, we conduct a laboratory experiment in which subjects spend their savings on consumption over 20 periods. In the control treatment, the commodity price is constant across all periods. In the small (large) price-fluctuation treatment, the price rate of change is always 1% (20%), and the rate of change of savings is always the same as the commodity price. Therefore, the optimal amount of consumption is the same in all three treatments. Our main findings are threefold. First, the magnitude of misconsumption (i.e., the deviation from optimal consumption) is significantly high in order of the control, small price-fluctuation, and large price-fluctuation treatments. Second, in the control treatment, the magnitude of misconsumption shrinks over time, whereas it gradually increases in the small and large price-fluctuation treatments. Finally, regardless of the presence of price fluctuations, subjects exhibit under-consumption (over-saving) behavior, and the presence of price fluctuations strengthens such a tendency.
    Date: 2014–11
  20. By: Yangui, Ahmed1; Akaichi, Faiçal; Costa-Font, Montserrat; Gil, Jose Maria
    Abstract: Parting from the issue which elicited value method best predict real consumer’ behavior, this study compares the ability of hypothetical and non-hypothetical choice experiment respect to incentive compatible ranking conjoint analysis and sequential best worst scaling in terms of estimated partworths, internal and external predictive power, estimated WTP, and participants’ response consistency. In general, the results reveal higher preferences regularity between the respondents across the different treatments implying not statistically difference in the marginal participants’ WTP. Additionally, the participants behave similarly whether there are asked to choose or to state their most preferred through two ranking elicitation mechanism. However, the advantage of the best worst scaling in it cognitive process which could be considered clearness for participants has been illustrated in statistical significant increment of external predictive power of the method compared with ranking conjoint analysis
    Keywords: conjoint analysis, best worst scaling, external validity, experimental economics, hypothetical bias, Consumer/Household Economics,
    Date: 2014–08
  21. By: Domikowsky, Christian; Bornemann, Sven; Duellmann, Klaus; Pfingsten, Andreas
    Abstract: Several studies have addressed, with conflicting results, the issue of procyclical effects of loan loss provisions in the past. More recently, the weak performance of incurred loss models in the financial crisis has given rise to a new debate on the sound design of credit risk provisioning schemes, which is reflected in the scheduled implementation of an expected loss model in IFRS 9. This study contributes to the extant literature by separately analyzing the cyclical effects of specific and general loan loss provisions under a legislative framework that allows provisions based on expected losses in the loan portfolio. Using three different measures of forward-looking provisioning, we find typical German banks, most of them unlisted and operating regionally, to use specific loan loss provisions countercyclically, in particular for earnings management and by anticipating non-performing loans at the closing date. The use of general loan loss provisions is predominantly motivated by tax considerations, pointing out the considerable importance of the impact of local tax law.
    Keywords: procyclicality,earnings management,hidden reserves,loan loss provisioning,expected losses,managerial discretion
    JEL: G01 G21 M41
    Date: 2014
  22. By: Knut Are Aastveit (Norges Bank (Central Bank of Norway)); Francesco Ravazzolo (Norges Bank (Central Bank of Norway) and BI Norwegian Business School); Herman K. van Dijk (Erasmus University Rotterdam, VU University Amsterdam and Tinbergen Institute,)
    Abstract: We introduce a Combined Density Nowcasting (CDN) approach to Dynamic Factor Models (DFM) that in a coherent way accounts for time-varying uncertainty of several model and data features in order to provide more accurate and complete density nowcasts. The combination weights are latent random variables that depend on past nowcasting performance and other learning mechanisms. The combined density scheme is incorporated in a Bayesian Sequential Monte Carlo method which re-balances the set of nowcasted densities in each period using updated information on the time-varying weights. Experiments with simulated data show that CDN works particularly well in a situation of early data releases with relatively large data uncertainty and model incompleteness. Empirical results, based on US real-time data of 120 leading indicators, indicate that CDN gives more accurate density nowcasts of US GDP growth than a model selection strategy and other combination strategies throughout the quarter with relatively large gains for the two rst months of the quarter. CDN also provides informative signals on model incompleteness during recent recessions. Focusing on the tails, CDN delivers probabilities of negative growth, that provide good signals for calling recessions and ending economic slumps in real time.
    Keywords: Density forecast combination, Survey forecast, Bayesian filtering; Sequential Monte Carlo Nowcasting; Real-time data
    JEL: C11 C13 C32 C53 E37
    Date: 2014–12–04
  23. By: D'Amico, Stefania (Federal Reserve Bank of Chicago); Orphanides, Athanasios (Federal Reserve Bank of Chicago)
    Abstract: This paper examines the relation between variations in perceived inflation uncertainty and bond premia. Using the subjective probability distributions available in the Survey of Professional Forecasters we construct a quarterly time series of average individual uncertainty about inflation forecasts since 1968. We show that this ex-ante measure of inflation uncertainty differs importantly from measures of disagreement regarding inflation forecasts and other proxies, such as model-based ex-post measures of macroeconomic risk. Inflation uncertainty is an important driver of bond premia, but the relation varies across inflation regimes. It is most important in the high-inflation regime early in the sample and the low-inflation regime over the last 15 years. Once the role of inflation uncertainty is accounted for, disagreement regarding inflation forecasts appears a much less important driver of bond premia.
    Keywords: Survey expectations; probabilistic forecasts; heterogeneity; inflation uncertainty; bond risk premia
    JEL: C53 E37 E44 E47 G12
    Date: 2014–01–11

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