nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2015‒02‒16
seventeen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Revealed preferences over risk and uncertainty By John Quah; Matthew Polisson; Ludovic Renou
  2. Detecting Heterogeneous Risk Attitudes with Mixed Gambles By Astebro , Thomas; Santos-Pinto , Luís
  3. Recursive utility and jump-diffusions By Aase, Knut K.
  4. Strotz meets Allais: Diminishing Impatience and the Certainty Effect: Reply and Corrigendum By Chakraborty, Anujit; Halevy, Yoram
  5. Incomplete Preferences and Confidence By Hill , Brian
  6. The Impact of Experience on Violations of Independence and Coalescing By Schmidt, Ulrich; Birnbaum, Michael
  7. Preferences and Exposure to Shocks: Evidence from a Natural Experiment in Palestine By Cavatorta, Elisa; Groom, Ben
  8. Life-Cycle Asset Allocation with Ambiguity Aversion and Learning By Kim Peijnenburg
  9. Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion By Herweg, Fabian; Karle, Heiko; Müller, Daniel
  10. The Great Schism in the Theory of Public Finance. A Treatise in the Theory of Economic Thought By Blankart, Charles B:
  11. Intertemporal Consumption and Debt Aversion: An Experimental Study By Meissner, Thomas
  12. Costly information acquisition and the temporal resolution of uncertainty By Daniele Pennesi
  13. A Bounded Rationality Model of Information Search and Choice in Preference Measurement By Yang , Cathy; Toubia, Olivier
  14. Hyperbolical Discounting and Endogenous Growth By Strulik, Holger
  15. Loss Aversion and Inefficient Renegotiation By Schmidt, Klaus; Herweg, Fabian
  16. Measuring the Economic Value of Sustainable River Basin Management: The Full-Preference Rank Method By Phoebe Koundouri; Osiel Gonzalez Davila; Theologos Pantelidis
  17. How Does Aging Affect Financial Decision Making? By Keith Jacks Gamble; Patricia A. Boyle; Lei Yu; David A. Bennett

  1. By: John Quah; Matthew Polisson; Ludovic Renou
    Abstract: Consider a finite data set where each observation consists of a bunde of contingent consumption chosen by an agent from a constraint set of such bundles.  We develop a general procedure for testing the consistency of this data set with a broad class of models of choice under risk and under uncertainty.  Unlike previous work, we do not require that the agent has a convex preference, so we allow for risk loving and elation seeking behavior.  Our procedure can also be extended to calculate the magnitude of violations from a particular model of choice, using an index first suggested by Afriat (1972, 1973).  We then apply this index to evaluate different models (including expected utility and disappointment aversion) in the data collected by Choi et al. (2007).  We show that more than half of all subjects exhibiting choice behavior consistent with utility maximization are also consistent with models of expected utility and disappointment aversion.
    Keywords: expected utility, rank dependent utility, maxmin expected utility, variational preferences, generalized axiom of revealed preference
    JEL: C14 C60 D11 D12 D81
    Date: 2015–02–05
  2. By: Astebro , Thomas; Santos-Pinto , Luís
    Abstract: The authors propose a task for eliciting attitudes towards risk that is close to real world risky decisions which typically involve gains and losses. The task consists of accepting or rejecting gambles that provide a gain with probability p and a loss with probability 1 p. The authors employ finite mixture models to uncover heterogeneity in risk preferences and find that (i) behavior is heterogeneous, with slightly less than one half of the subjects behaving as expected utility maximizers, (ii) for the others, reference-dependent models perform better than those where subjects derive utility from final outcomes, (iii) models with sign dependent decision weights perform better than those without, and (iv) there is no evidence for loss aversion. The procedure is sufficiently simple so that it can be easily used in field or lab experiments where risk elicitation is not the main experiment.
    Keywords: Individual risk taking behavior; latent heterogeneity; finite mixture models; reference-dependence; loss aversion
    JEL: C91 D81
    Date: 2014–03–28
  3. By: Aase, Knut K. (Dept. of Business and Management Science, Norwegian School of Economics)
    Abstract: We derive the equilibrium interest rate and risk premiums using recursive utility for jump-diffusions. Compared to to the continuous version, including jumps allows for a separate risk aversion related to jump size risk in addition to risk aversion related to the continuous part. The jump part also introduces moments of higher orders that may matter in many circumstances. We consider the version of recursive utility which gives the most unambiguous separation of risk preference from time substitution, and use the stochastic maximum principle to analyze the model. This method uses forward/backward stochastic differential equations. We demonstrate how the stochastic process for the market portfolio is determined in terms the corresponding processes for future utility and aggregate consumption. It is indicated that this model has the potential to give reasonable explanations of empirical puzzles.
    Keywords: Recursive utility; jump dynamics; the stochastic maximum principle
    JEL: D51 D53 D90 E21 G10 G12
    Date: 2015–01–30
  4. By: Chakraborty, Anujit; Halevy, Yoram
    Abstract: Halevy (2008) establishes a relation between non-standard behaviors in the domains of risk and time. A decision maker who believes that only present consumption is certain while any future consumption is uncertain exhibits diminishing impatience if and only if her preferences on the risk domain are represented by a non-expected utility function. Contrary to previous claims (Halevy, 2008; Saito, 2011) we demonstrate that diminishing impatience does not necessarily imply the certainty effect. If diminishing impatience is invariant to the scale in which time is measured, then the severed connection between time and risk preferences can be re-established.
    Keywords: hyperbolic discounting, present bias, non-expected utility, prospect theory
    JEL: D03 D81 C91
    Date: 2015–02–07
  5. By: Hill , Brian
    Abstract: A theory of incomplete preferences under uncertainty is proposed, according to which a decision maker’s preferences are indeterminate if and only if her confidence in the relevant beliefs does not match up to the stakes involved in the decision. The author uses the model of confidence in beliefs introduced in Hill (2013), and axiomatise a class of models, differing from each other in the appropriate notion of stakes. Comparative statics analysis can distinguish the decision maker’s confidence from her attitude to choosing in the absence of confidence. The model naturally suggests two possible strategies for completing preferences, and hence for choosing in the presence of incompleteness. One strategy respects confidence – it relies only on beliefs in which the decision maker has sufficient confidence given the stakes – whereas the other goes on hunches – it relies on all beliefs, no matter how little confidence the decision maker has in them. Axiomatic characterizations are given for each of the strategies. Finally, the author considers the consequences of the model in markets, where indeterminacy of preference translates into refusal to trade. The incorporation of confidence adds an extra friction, beyond the standard implications of non-expected utility models for Pareto optima.
    Keywords: Incomplete preferences; confidence; multiple priors; choice under incomplete preferences; absence of trade
    JEL: D01 D53 D81
    Date: 2014–07–31
  6. By: Schmidt, Ulrich; Birnbaum, Michael
    Abstract: The present paper reports a repeated experiment on decision making under risk where subjects have to tackle the same choice problems in several rounds. We fit a simple error model and investigate how behavior changes in the course of the experiment. Our analysis complements and extends Hey (2001) who analyzes for each subject the fit of several preference functionals from round to round. Instead, we focus on choice problems allowing for direct tests of independence and coalescing. We show that variability of responses as well as violations of independence and coalescing decrease from earlier to later rounds. Our results provide evidence in favor of expected utility in conjunction with the discovered preference hypothesis.
    JEL: C91 D81 C19
    Date: 2014
  7. By: Cavatorta, Elisa; Groom, Ben
    Abstract: We use a series of field experiments in the Palestinian Territories to explore the impact of exposure to shocks on risk, time and ambiguity preferences. We exploit the historical episode of the construction of the separation wall between the State of Israel and the West Bank as an exogenous shock to test changes in fundamental preferences. We find that the wall affects preferences: people in isolated communities are significantly more risk-tolerant and ambiguity-averse than people who never experienced the wall. While we find insignificant differences in discount rates and loss-aversion, our results show patterns of time-varying discount rates and heterogeneity across socio-economic groups. We test alternative mechanisms linking shocks to changes in behaviour. Our evidence suggests that observed differences in risk and ambiguity are not the result of changes in subjective beliefs, learning or emotional reactions, but they are consistent with the hypothesis of a preference shift. This study suggests that large adverse shocks may have long-lasting consequences on individual decision-making with potential effects on savings, investments and consumption patterns.
    JEL: C93 O12 D81
    Date: 2014
  8. By: Kim Peijnenburg (Bocconi University)
    Abstract: I show that ambiguity (Knightian uncertainty) and learning about the equity premium can simultane- ously explain the low fraction of financial wealth allocated to stocks over the life cycle as well as the stock market participation puzzle. I assume that individuals are ambiguous about the size of the equity premium and are averse with respect to this ambiguity, which results in a lower optimal allocation to stocks over the life cycle. As agents get older, they learn about the equity premium and increase their allocation to stocks. Furthermore, I find that ambiguity aversion leads to higher saving rates.
    Date: 2014
  9. By: Herweg, Fabian; Karle, Heiko; Müller, Daniel
    Abstract: We consider a simple trading relationship between an expectation-based loss-averse buyer and profit-maximizing sellers. When writing a long-term contract the parties have to rely on renegotiations in order to ensure materially efficient trade ex post. The type of the concluded long-term contract affects the buyer's expectations regarding the outcome of renegotiation. If the buyer expects renegotiation always to take place, the parties are always able to implement the materially efficient good ex post. It can be optimal for the buyer, however, to expect that renegotiation does not take place. In this case, a good of too high quality or too low quality is traded ex post. Based on the buyer's expectation management, our theory provides a rationale for ``employment contracts'' in the absence of non-contractible investments. Moreover, in an extension with non-contractible investments, we show that loss aversion can reduce the hold-up problem.
    JEL: C78 D82 D03
    Date: 2014
  10. By: Blankart, Charles B:
    Abstract: In 1870 Menger, Jevons and Walras succeeded in explaining prices in a market economy. While most economists welcomed their achievement, economists of the theory of public finance split in a Great Schism. The dissent is on the two Gossen Laws on which the neoclassical revolution relies. Continental Europeans insist in the relevance of choice and therefore adopt both Gossen laws, meaning that of declining marginal utility and that of utility equalization at the margin. The Anglo-Saxons adopt only declining marginal utility because they found that individual choice does not work for public goods. The former became choice individualists, the latter utilitarians. The Schism was revitalized with the Mirrlees Review of 2010/2011, a monumental work by 63 renowned economists over 1880 pages on what a good tax system ought to be. The author argues that without choice, nothing can be said on a good tax system. Therefore the Mirrlees Review is rejected in favour of a choice alternative which is developed in this paper.
    JEL: A20 B50 H20
    Date: 2014
  11. By: Meissner, Thomas
    Abstract: This paper tests how subjects behave in an intertemporal consumption/saving experiment when borrowing is allowed and whether subjects treat debt differently than savings. Two treatments create environments where either saving or borrowing is required for optimal consumption. Since both treatments share the same optimal consumption levels, actual consumption choices can be directly compared across treatments. The experimental findings imply that deviations from optimal behavior are higher when subjects have to borrow than when they have to save in order to consume optimally, suggesting debt-aversion. Signifiant underconsumption is observed when subjects have to borrow in order to reach optimal consumption. Only weak evidence is found suggesting that subjects over-consume when saving is necessary for optimal consumption.
    JEL: C91 E21 D91
    Date: 2014
  12. By: Daniele Pennesi (Université de Cergy-Pontoise, THEMA)
    Abstract: This paper studies the choice of an individual who acquires information before choosing an action froma set of actions,whose consequences depend on the realization of a state of nature. Information processing can be costly, for example, due to limited attention. We show that the preference of the individual over sets of actions, is completely characterized by a preference for early resolution of uncertainty who becomes indifference when facing degenerate choices. When information acquisition is no longer part of the decision process, the individual is indifferent to the timing of resolution of uncertainty and she behaves according to the subjective learning model of Dillenberger et al. (2014).
    Keywords: Costly Information acquisition, Menu Choice, Rational Inattention, Timing of Resolution of Uncertainty
    JEL: D01 D9 D8
    Date: 2015
  13. By: Yang , Cathy; Toubia, Olivier
    Abstract: It is becoming increasingly easier for researchers and practitioners to collect eye tracking data during online preference measurement tasks. The authors develop a dynamic discrete choice model of information search and choice under bounded rationality, that they calibrate using a combination of eye-tracking and choice data. Their model extends the directed cognition model of Gabaix et al. (2006) by capturing fatigue, proximity effects, and imperfect memory encoding and by estimating individual-level parameters and partworths within a likelihood-based, hierarchical Bayesian framework. The authors show that modeling eye movements as the outcome of forward-looking utility maximization improves out-of-sample predictions, enables researchers and practitioners to use shorter questionnaires, and allows better discrimination between attributes.
    Keywords: Preference Measurement; Incentive Compatibility; Eye Tracking; Dynamic Discrete Choice Models
    JEL: D83 M31
    Date: 2014–10–14
  14. By: Strulik, Holger
    Abstract: This paper provides the exact analytical solution for the standard model of endogenous growth when consumers have present-biased preferences and make time-inconsistent savings plans, which they revise continuously. It is shown that long-run growth is not necessarily lower under present-biased preferences. In fact, an equivalence result holds. If hyperbolical discounting provides the same present value of a constant infinite income stream as standard exponential discounting, then the equilibrium rate of economic growth is also the same under both discounting methods. In this sense present-bias and the entailed time-inconsistency of savings plans are harmless for economic growth. The result is robust to the introduction of non-homothetic utility and a variable elasticity of intertemporal substitution in consumption.
    JEL: O40 D91 E21
    Date: 2014
  15. By: Schmidt, Klaus; Herweg, Fabian
    Abstract: We propose a theory of inefficient renegotiation that is based on loss aversion. When two parties write a long-term contract that has to be renegoti- ated after the realization of the state of the world, they take the initial contract as a reference point to which they compare gains and losses of the renegotiated transaction. We show that loss aversion makes the renegotiated outcome sticky and materially inefficient. The theory has important implications for the optimal design of long-term contracts. First, it explains why parties often abstain from writing a beneficial long-term contract or why some contracts specify transactions that are never ex post efficient. Second, it shows under what conditions parties should rely on the allocation of ownership rights to protect relationship-specific investments rather than writing a specific performance contract. Third, it shows that employment contracts can be strictly optimal even if parties are free to rene- gotiate.
    JEL: C78 D03 D86
    Date: 2014
  16. By: Phoebe Koundouri; Osiel Gonzalez Davila; Theologos Pantelidis
    Abstract: This study exploits the data from a full-preference ranking Choice Experiment (CE) designed to investigate how respondents evaluate a set of proposed improvements in the Asopos water catchment in Greece. These improvements are following the prescriptions of the European Union Water Framework Directive (2000). We first estimate a rank-ordered logistic regression based on the full set of choices by respondents to calculate the willingness to pay (WTP) of respondents for each one of the three attributes considered in the CE (that is, environmental conditions, impact on the local economy and changes in the potential uses of water). The model is initially estimated for the full sample and then re-estimated twice for two sub-samples: the one includes only the residents of Athens and the other includes only the residents of Asopos. Afterwards, we examine the effect of various demographic and socio-economic factors (such as income, gender, age, employment and education) on the estimates of our model in an attempt to reveal any differences among respondents with different characteristics. Thus, our analysis simultaneously provides a robustness check on previous findings in the literature and additional information about how various demographic and socio-economic characteristics affect the evaluation of the selected attributes.
    Keywords: Choice experiment, Full-preference ranking, Logistic regression, Asopos River Basin, Environmental degradation, Water quality and quantity; Random utility maximization; Logit probabilities; Water Framework Directive; Residency-specific use and non-use val
    JEL: Q25 Q51 Q53
    Date: 2015–02–05
  17. By: Keith Jacks Gamble; Patricia A. Boyle; Lei Yu; David A. Bennett
    Abstract: The brief’s key findings are: *With the shift from traditional pensions to 401(k) plans, the welfare of retirees depends increasingly on their ability to make sound financial decisions. *Using a dataset that follows a group of older individuals in the Chicago area, the analysis examines how aging affects financial decision making. *Participants who suffer cognitive decline experience a reduction in their financial literacy but no change in their confidence in managing their money. *Perhaps not surprisingly then, while they are more likely to get help with financial decisions, more than half retain primary responsibility for managing their money.

This nep-upt issue is ©2015 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.