nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2015‒04‒02
twenty-one papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Ambiguity aversion is the exception By Martin G. Kocher; Amrei Marie Lahno; Stefan T. Trautmann
  2. Dynamic indifference pricing via the G-expectation By Qian Lin
  3. The Subjective Discount Factor and Risk Aversion, Loss Aversion and uncertainty By Jiri Rotschedl
  4. Monotonic Aggregation of Preferences and the Rationalization of Choice Functions By Jerry R. Green; Daniel Hojman
  5. Indifference Pricing and Hedging in a Multiple-Priors Model with Trading Constraints By Huiwen Yan; Gechun Liang; Zhou Yang
  7. Parenthood and risk preferences By Görlitz, Katja; Tamm, Marcus
  8. Less is more: increasing retirement gains by using an upside terminal wealth constraint By Catherine Donnelly; Russell Gerrard; Montserrat Guillén; Jens Perch Nielsen
  9. The effects of emotions on preferences and choices for public goods By Christopher Boyce; Mikolaj Czajkowski; Nick Hanley; ; Charles Noussair; Michael Townsend; Steve Tucker
  10. The Impact of Entrepreneurial Risk Aversion on Wages in General Equilibrium By Ying Feng; James E. Rauch
  11. Uncertainty Aversion and Systemic Risk By Dicks, David L.; Fulghieri, Paolo
  12. The Marriage Market, Labor Supply and Education Choice By Pierre-Andre Chiappori; Monica Costa Dias; Costas Meghir
  13. Valuation of Safety under Reference-Dependent Evaluation of Income By José Antonio Robles-Zurita
  14. Bilateral trade with loss-averse agents By Jean-Michel Benkert
  15. Relative Social Status and Conflicting Measures of Poverty: A Behavioural Analytical Model By Sugata Marjit; Arijit Mukherjee; Koushik Kumar Hati
  16. Re-examining empirical evidence on contingent valuation – Importance of incentive compatibility By Ewa Zawojska; Mikołaj Czajkowski
  17. Anticipations and Endogenous Present Bias By Simone Galperti; Bruno Strulovici
  18. The Rotterdam Demand Model Half a Century On By Kenneth W Clements; Grace Gao
  19. Uncertainty Avoiding Behavior and Cross-border Acquisitions By Marc BREMER; HOSHI Akio; INOUE Kotaro; SUZUKI Kazunori
  20. The Welfare Effects of Coordinated Assignment: Evidence from the NYC HS Match By Atila Abdulkadiroğlu; Nikhil Agarwal; Parag A. Pathak
  21. Equal distribution or equal payoffs? Reciprocity and inequality aversion in the investment game By Rodriguez-lara, Ismael

  1. By: Martin G. Kocher; Amrei Marie Lahno; Stefan T. Trautmann
    Abstract: An extensive literature has studied ambiguity aversion in economic decision making, and how ambiguity aversion can account for empirically observed violations of expected utility-based theories. Almost all relevant applied models presume a general dislike of ambiguity. In this paper, we provide a systematic experimental assessment of ambiguity attitudes in different likelihood ranges and in the gain domain, the loss domain and with mixed outcomes. We draw on a unified framework with more than 500 participants and find that ambiguity aversion is the exception, not the rule. We replicate the usual finding of ambiguity aversion for moderate likelihood gains. However, when introducing losses or lower likelihoods, we observe either ambiguity neutrality or even ambiguity seeking behavior. Our results are robust to different elicitation procedures.
    Keywords: ambiguity aversion, decision under uncertainty, Ellsberg experiments
    JEL: C91 D81
    Date: 2015–03–11
  2. By: Qian Lin
    Abstract: We study the dynamic indifference pricing with ambiguity preferences. For this, we introduce the dynamic expected utility with ambiguity via the nonlinear expectation--G-expectation, introduced by Peng (2007). We also study the risk aversion and certainty equivalent for the agents with ambiguity. We obtain the dynamic consistency of indifference pricing with ambiguity preferences. Finally, we obtain comparative statics.
    Date: 2015–03
  3. By: Jiri Rotschedl (University of Economics, Prague)
    Abstract: The author derives a new concept model of discounting utility function or consumption on a theoretical basis. He surveys the formation and evolution models of the subjective discount factor. This paper focuses on exponential and hyperbolic discounting utility model, which belongs to the mainstream of economics for its simplicity. The aim of this paper is to add to the generalized hyperbolic model parameters representing the effect of uncertainty in the intertemporal decision making. The paper presents connection with the neoclassical and hedonic approach that the parameters introduced in the model are mainly psychological factors (risk aversion, loss aversion, etc.). By using the final model can explain why subjective discount factor is increasing, although subjective discount rate (patience consumption) is positive and also increasing.
    Keywords: Subjective discount factor, risk aversion, loss aversion,
    JEL: D90 D11
    Date: 2014–10
  4. By: Jerry R. Green; Daniel Hojman
    Abstract: We consider a decision maker that holds multiple preferences simultaneously, each with different strengths described by a probability distribution. Faced with a subset of available alternatives, the preferences held by the individual can be in conflict. Choice results from an aggregation of these preferences. We assume that the aggregation method is monotonic: improvements in the position of alternative x cannot displace x if it were originally the choice. We show that choices made in this manner can be represented by context-dependent utility functions that are monotonic with respect to a measure of the strength of each alternative among those available. Using this representation we show that any generic monotonic rule can generate an arbitrary choice function as we vary the distribution of preferences. Domain restrictions on the set of preferences (e.g. dual motivation models) or consistency restrictions on the aggregator across choice sets reduce the set of admissible behaviors. Applications to positive models of individual decision making with context effects and social choice are discussed.
    Date: 2015–03
  5. By: Huiwen Yan; Gechun Liang; Zhou Yang
    Abstract: This paper considers utility indifference valuation of derivatives under model uncertainty and trading constraints, where the utility is formulated as an additive stochastic differential utility of both intertemporal consumption and terminal wealth, and the uncertain prospects are ranked according to a multiple-priors model of Chen and Epstein (2002). The price is determined by two optimal stochastic control problems (mixed with optimal stopping time in the case of American option) of forward-backward stochastic differential equations. By means of backward stochastic differential equation and partial differential equation methods, we show that both bid and ask prices are closely related to the Black-Scholes risk-neutral price with modified dividend rates. The two prices will actually coincide with each other if there is no trading constraint or the model uncertainty disappears. Finally, two applications to European option and American option are discussed.
    Date: 2015–03
  6. By: Francesco Bogliacino; Iván González Gallo
    Abstract: In this article we test the main hypotheses of the behavioural theory of entrepreneurship, namely that risk preferences are reference-dependent, that entrepreneurs are not ambiguity-averse and that aspirations act as a reference point in the sense postulated by Prospect Theory. We use an experimental methodology to elicit risk preferences and we manipulate aspirations by means of a psychological priming technique to guarantee exogenous variation of the independent variable. We also assess the relationship between risk preferences and correlates at the firm and individual level. Although causality cannot be established, as expected the risk preferences are mainly related with individual characteristics. If we look at the relationship between biases and firm performance we see some effect of loss aversion in interaction with personality traits (locus of control) and level of risk propensity. Our experimental fieldwork has been conducted in Colombia.
    Keywords: Experiments, Prospect Theory, Aspirations, Entrepreneurship.
    JEL: C93 D81 L26 O54
    Date: 2015–03–20
  7. By: Görlitz, Katja; Tamm, Marcus
    Abstract: This study analyzes how risk attitudes change when individuals become parents using longitudinal data for a large and representative sample of individuals. The results show that men and women experience a considerable increase in risk aversion which already starts as early as two years before becoming a parent, is largest shortly after giving birth and disappears when the child becomes older. These findings show that parenthood leads to considerable changes in individual risk attitudes over time. Thus, analyses using risk preferences as the explanatory variable for economic outcomes should be careful in interpreting the findings as causal effects.
    Keywords: risk aversion,risk preferences,preference stability,parenthood,children,gender differences
    JEL: D1 D81 J13 J16
    Date: 2015
  8. By: Catherine Donnelly (Department of Actuarial Mathematics and Statistics, and the Maxwell Institute for Mathematical Sciences, Heriot-Watt University); Russell Gerrard (Cass Business School, City University London); Montserrat Guillén (Department of Econometrics, Riskcenter-IREA, Universitat de Barcelona); Jens Perch Nielsen (Cass Business School, City University London)
    Abstract: We solve a portfolio selection problem of an investor with a deterministic savings plan who aims to have a target wealth value at retirement. The investor is an expected power utility-maximizer. The target wealth value is the maximum wealth that the investor can have at retirement. By constraining the investor to have no more than the target wealth at retirement, we find that the lower quantiles of the terminal wealth distribution increase, so the risk of poor financial outcomes is reduced. The drawback of the optimal strategy is that the possibility of gains above the target wealth are eliminated.
    Keywords: Pension, Savings, Annuity, Investment, Retirement planning
    Date: 2015–02
  9. By: Christopher Boyce (Management School,University of Stirling, Scotland, UK); Mikolaj Czajkowski (University of Warsaw, Department of Economic Sciences, Poland); Nick Hanley (Department of Geography and Sustainable Development, University of St. Andrews); (Department of Geography and Sustainable Development, University of St. Andrews); Charles Noussair (Department of Economics, Tilburg University, the Netherlands); Michael Townsend (National Institute for Water and Atmosphere Ltd, Hamilton, New Zealand); Steve Tucker (School of Management, University of Waikato, New Zealand)
    Abstract: This paper tests whether changes in “incidental emotions” lead to changes in economic choices. Incidental emotions are experienced at the time of an economic decision but are not part of the payoff from a particular choice. As such, the standard economic model predicts that incidental emotions should not affect behavior, yet many papers in the behavioral science and psychology literatures find evidence of such effects. In this paper, we used a standard procedure to induce different incidental emotional states in respondents, and then carried out a choice experiment on changes to an environmental good (beach quality). We estimated preferences for this environmental good and willingness to pay for changes in this good, and tested whether these were dependent on the particular emotional state induced. We also tested whether choices became more or less random when emotional states were induced, based on the notion of randomness in a standard random utility model. Contrary to our a-priori hypothesis we found no significant evidence of treatment effects, implying that economists need not worry about the effects of variations in incidental emotions on preferences and the randomness of choice, even when there is measured (induced) variation in these emotions.
    Keywords: choice experiments, behavioral economics, ecosystem services, emotions, rationality
    JEL: Q51 Q57 D03 D87
    Date: 2015–03
  10. By: Ying Feng; James E. Rauch
    Abstract: One of the leading theories of entrepreneurship is that less risk averse individuals become entrepreneurs and more risk averse individuals become their employees. Kihlstrom and Laffont (1979) formalized this insight in an elegant and widely taught general equilibrium model. However, their model has not been further developed. A reason may be that their main comparative static result, that an economy-wide increase in risk aversion lowers the equilibrium wage, appeared to require the assumption that all agents had identical risk aversion index, throwing out their motivating insight and indicating that the model is intractable. In this note we prove this comparative static result on risk aversion and wages in general equilibrium, retaining agent heterogeneity in risk aversion and the endogenous division of agents into less risk averse entrepreneurs and more risk averse workers, without adding any assumptions not already in the original paper. Besides the intrinsic value of the result, we hope to increase the usefulness of the Kihlstrom and Laffont (1979) model for other researchers and to facilitate improvement in its exposition for the many graduate courses in which it is taught.
    JEL: L26
    Date: 2015–03
  11. By: Dicks, David L.; Fulghieri, Paolo
    Abstract: We propose a new theory of systemic risk based on Knightian uncertainty (or "ambiguity"). We show that, due to uncertainty aversion, beliefs on future asset returns are endogenous, and bad news on one asset class induces investors to be more pessimistic about other asset classes as well. This means that idiosyncratic risk can create contagion and snowball into systemic risk. Furthermore, in a Diamond and Dybvig (1983) setting, we show that, surprisingly, uncertainty aversion causes investors to be less prone to run individual banks, but runs will be systemic. In addition, we show that bank runs are associated with stock market crashes and flight to quality. Finally, we argue that increasing uncertainty makes the financial system more fragile and more prone to crises. We conclude with implications for the current public policy debate on the management of financial crisis
    Keywords: Ambiguity Aversion; Bank Runs; Financial Crises; Systemic Risk
    JEL: G01 G21 G28
    Date: 2015–03
  12. By: Pierre-Andre Chiappori (Dept. of Economics, Columbia University); Monica Costa Dias (Institute for Fiscal Studies); Costas Meghir (Cowles Foundation, Yale University)
    Abstract: We develop an equilibrium lifecycle model of education, marriage and labor supply and consumption in a transferable utility context. Individuals start by choosing their investments in education anticipating returns in the marriage market and the labor market. They then match based on the economic value of marriage and on preferences. Equilibrium in the marriage market determines intrahousehold allocation of resources. Following marriage households (married or single) save, supply labor and consume private and public under uncertainty. Marriage thus has the dual role of providing public goods and offering risk sharing. The model is estimated using the British HPS.
    Keywords: Marriage market, Human capital, Labor supply, Life cycle models, Intrahousehold allocations, Collective model, Education choice, Returns to education
    JEL: J12 J16 J22 J24 H31 I24
    Date: 2015–03
  13. By: José Antonio Robles-Zurita (Department of Economics, Universidad Pablo de Olavide)
    Abstract: We analyze data of a Spanish nationally-representative survey where subjects reported their Willingness To Pay (WTP) for road safety improvements; specifically they hypothetically paid for a reduction of the risk of a road fatality and several injuries. Respondents also reported their current income (CI) and permanent income (PI). The latter refers to their normal income once they considered various stages of low/high earnings throughout their entire lives. Consequently, we define relative income as the comparison of CI with respect to PI. Three income frames are generated as explanatory variables: Gain (with CI>PI); Neutral (with CI=PI); and Loss scenario (with CI<PI). Surprisingly, we find that conditional on current income, and on a set of characteristics, those respondents in gain frame reported higher WTP than those in neutral and loss scenario. Further analysis shows that the income frames effect is higher and more significant for the older half-sample (>45), being about three or four times higher than for the younger subset. Possible interpretations of the role of PI as a reference point are considered given the results. A reference-dependent utility function of income, where PI is the reference point, is proposed to describe the monetary valuation of safety within the theoretical framework previously developed in the safety economics literature.
    Keywords: reference-dependent; relative income, willingness to pay, road safety, contingent valuation
    JEL: I10 D61 D12
    Date: 2015–03
  14. By: Jean-Michel Benkert
    Abstract: We study the bilateral trade problem put forward by Myerson and Satterthwaite (1983) under the assumption that agents are loss-averse. We use the model developed by Kőszegi and Rabin (2006, 2007) to find optimal mechanisms for the minimal subsidy, revenue maximization and welfare maximization problem. In both, welfare and revenue maximizing mechanisms, the designer induces less trade in the presence of loss-aversion. Intuitively, the designer is providing the agents with partial insurance. Moreover, the designer optimally provides the agents with full insurance in the money dimension, i.e. she offers deterministic transfers. Another implication of loss-aversion is that it increases the severity of the impossibility problem, that is, the minimal subsidy needed to induce materially efficient trade is higher. All results display robustness to the exact specification of the reference point. We also provide some general mechanism design results.
    Keywords: Bilateral trade, loss-aversion, mechanism design, deterministic transfers
    JEL: C78 D02 D03 D82 D84
    Date: 2015–03
  15. By: Sugata Marjit; Arijit Mukherjee; Koushik Kumar Hati
    Abstract: We consider a situation where the relatively ‘poor’ are concerned about their relative income status with respect to a relevant reference group. Such a concern is explicitly introduced in a utility function to study the consumption behavior of the poor. We point towards a possible conflict between income based and nutrition-based measure of poverty. Changes in income distribution generate non-homothetic outcome for an “otherwise homothetic” preference structure and may convert an “otherwise normal” good into an inferior good.
    Keywords: Status; Consumption pattern; Inequality; Poverty JEL Classification: C13, D01, D12, O40
    Date: 2015
  16. By: Ewa Zawojska (Faculty of Economic Sciences, University of Warsaw); Mikołaj Czajkowski (Faculty of Economic Sciences, University of Warsaw)
    Abstract: The contingent valuation (CV) method uses respondents’ stated choices made in hypothetical situations to infer their preferences for environmental public goods. It enables the general public’s preferences to be stated in monetary terms and hence to estimate the economic value of a change in the quantity or quality of the goods. However, a key question remains regarding CV’s validity: do the value estimates obtained from a CV study reflect respondents’ true preferences and their maximum willingness to pay? Numerous empirical investigations have tested CV’s validity, but overall conclusions are mixed. We critically re-evaluate this evidence considering the issue of incentive compatibility in contingent valuation settings for which the necessary conditions were recently proposed by Carson and Groves (2007). Our analysis shows that once incentive compatibility conditions are considered, the available studies consistently show that the CV method is valid. As a result, we argue that contingent scenarios and elicitation formats must be made incentive compatible in order to observe consumers’ true preferences.
    Keywords: contingent valuation, stated preference, validity, incentive compatibility
    JEL: Q51 H4 D6
    Date: 2015
  17. By: Simone Galperti; Bruno Strulovici
    Keywords: Anticipation, Cognitive Skill, Discounting, Human Capital, Impatience, Present Bias, Time Preference shocks, risk aversion. JEL Classification: D01, D03, D90, D91
    Date: 2015–03–26
  18. By: Kenneth W Clements (Business School, University of Western Australia); Grace Gao (Bankwest Curtin Economics Centre, Curtin University)
    Abstract: Half a century ago, Barten (1964) and Theil (1965) formulated what is now known as the Rotterdam model. A path-breaking innovation, this system of demand equations allowed for the first time rigorous testing of the theory of the utility-maximising consumer. This has led to a vibrant, on-going strand of research on the theoretical underpinnings of the model, extensions and numerous applications. But perhaps due to its European heritage and unorthodox derivation, there is still misunderstanding and a tendency for the Rotterdam model to be regarded with reservations and/or uncertainties (if not mistrust). This paper marks the golden jubilee of the model by clarifying its economic foundations, highlighting its strengths and weaknesses, elucidating its links with other models of consumer demand, and dealing with some recent developments that have their roots in Barten and Theil’s pioneering research of the 1960s.
    Date: 2014
  19. By: Marc BREMER; HOSHI Akio; INOUE Kotaro; SUZUKI Kazunori
    Abstract: The influence of managerial attitudes on corporate finance has become a topic of great interest. For example, Malmendier and Tate (2008) show that overconfident managers are more likely to conduct acquisitions. This research explores the impact of national business cultures on cross-border acquisitions. Business cultures can influence the ways managers cope with uncertainty and their subsequent business decisions, as was described in seminal research by Hofstede (1991). By their very nature, cross-border acquisitions require that managers deal with different cultures and higher levels of uncertainty. We seek to understand how business cultures affect value in cross-border acquisitions using data from the Asia-Pacific Rim region over the period 2000-2009. The countries in this region have large cultural differences, and the potential gains from acquisitions are very substantial, so these data are an excellent population for analysis. Our results show that different business cultures have an important influence on financial decisions by firms in ways that are consistent with classic research by Knight (2006), and also that different business cultures cope with uncertainty in different ways. We find that acquirers from countries with a high aversion to uncertainty conduct fewer cross-border acquisitions. Furthermore, these high uncertainty averse firms pay a higher price for control in cross-border deals.
    Date: 2015–03
  20. By: Atila Abdulkadiroğlu; Nikhil Agarwal; Parag A. Pathak
    Abstract: Centralized and coordinated school assignment systems are a growing part of recent education reforms. This paper estimates school demand using rank order lists submitted in New York City's high school assignment system launched in Fall 2003 to study the effects of coordinating admissions in a single-offer mechanism based on the deferred acceptance algorithm. In the previous mechanism, students were allowed to rank five choices and admissions offers were not coordinated across schools. While 18% of students obtained multiple first round offers, the mechanism's uncoordinated offers led more than a third of students to be unassigned after the main round and ultimately administratively assigned. Under the new mechanism, there is a 7.2 percentage point increase in matriculation at assigned school and students are assigned to schools that are on average 0.69 miles further from home. Even though students prefer nearby schools, our estimates suggest substantial heterogeneity in willingness to travel for school. The new mechanism generates higher utility on average and across numerous subgroups of students compared to either a neighborhood school alternative or the previous uncoordinated mechanism. Across a range of estimates, we find that the average student's welfare gain from coordinating assignment is substantially more than the disutility from increased travel. These gains are significantly larger than those from relaxing mechanism design constraints within the coordinated system. Preference heterogeneity implies that choice is far from zero-sum and coordinating admissions offers across schools increases allocative efficiency.
    JEL: C78 D50 D61 I21
    Date: 2015–03
  21. By: Rodriguez-lara, Ismael
    Abstract: We report experimental evidence on second-movers' behavior in the investment game (also known as the trust game) when there exists endowment heterogeneity. Using a within-subject analysis, we investigate whether second-movers have a tendency to be reciprocal (i.e., they return to first movers at least what they have received from them), or exhibit some taste for inequality aversion (i.e., they return a larger (smaller) share of the available funds to first-movers who are initially endowed with a lesser (larger) endowment, respectively). Our results suggest that second-movers' behavior is consistent across distribution of endowments, what indicates that second-movers (on average) do not take into consideration the level of endowments when making their decisions. This finding, in turn, implies that subjects behave according to our definition of reciprocity and that inequality-aversion receives little support from our data.
    Keywords: reciprocity, inequality aversion, investment game, trust game, endowment heterogeneity
    JEL: C72 C91 D3 D63
    Date: 2015–03–25

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