nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2015‒09‒26
sixteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Revealed incomplete preferences under uncertainty By Cettolin E.; Riedl A.M.
  2. Second order beliefs models of choice under imprecise risk: Nonadditive second order beliefs versus nonlinear second order utility By Raphaël Giraud
  3. Good Approximation of Exponential Utility Function for Optimal Futures Hedging By Guo, Xu; Lien, Donald; Wong, Wing-Keung
  4. An empirical investigation into the propensity of reckless decision making within the high pressure environment of Deal or No Deal. By Whitle, Richard; Rae, Jonathan; Pyke, Chris
  5. Stochastic Optimal Growth Model with Risk Sensitive Preferences By Nicole B\"auerle; Anna Ja\'skiewicz
  6. The pricing of contingent claims and optimal positions in asymptotically complete markets By Michail Anthropelos; Scott Robertson; Konstantinos Spiliopoulos
  7. Optimal Insurance with Rank-Dependent Utility and Increasing Indemnities By Xu Zuo Quan; Zhou Xun Yu; Zhuang Sheng Chao
  8. Decreasing Transaction Costs and Endogenous Fluctuations in a Monetary Model By Antoine Le Riche; Francesco Magris
  9. Do individuals’ risk and time preferences predict entrepreneurial choice? By Cook, William; Whittle, Richard
  10. Reference Point Formation By Koedijk, Kees; Noussair, Charles; Pownall, Rachel A J; Terzi, Ayse
  11. Ambiguity, Optimism, and Pessimism in Adverse Selection Models By Raphaël Giraud; Lionel Thomas
  12. Frequentist inference in spatial discrete choice models with endogenous congestion effects and club-correlated random effects By Arnab Bhattacharjee; Robert L. Hicks; Kurt E. Schnier
  13. Delegated Portfolio Management, Benchmarking, and the Effects on Financial Markets By Deniz Igan; Marcelo Pinheiro
  15. Climate damages on production or on growth: what impact on the social cost of carbon By Céline Guivarch; Antonin Pottier
  16. Reconciling yield stability with international fisheries agencies precautionary preferences: the role of non constant discount factors in age structured models By Gutiérrez Huerta, María José; Da Rocha, José María; Touza, Julia; García-Cutrín, Javier

  1. By: Cettolin E.; Riedl A.M. (GSBE)
    Abstract: The completeness axiom of choice has been questioned for long, and in response, theoretical models of decision making allowing for incomplete preferences have been developed. So far the theoretical accomplishments have however not been paired with empirical evidence on the actual existence of incomplete preferences. In this paper we provide empirical evidence in support of the existence of incomplete preferences due to multiple priors over an ambiguous event. We design experimental decision tasks where specific choice patterns are consistent with incomplete preferences under uncertainty but inconsistent with models assuming complete preferences. We find that approximately half of the subjects behave consistent with incomplete preferences due to multiple priors and that the observed behavioral pattern cannot be attributed to mistakes, probability weighting or regret aversion. In a robustness test we show that the observed behavior is robust to a prize variation in the ambiguous prospect and consistent with comparative statics predictions based on incomplete preferences under uncertainty.
    Keywords: Design of Experiments: Laboratory, Individual; Microeconomic Behavior: Underlying Principles; Criteria for Decision-Making under Risk and Uncertainty;
    JEL: C91 D01 D81
    Date: 2015
  2. By: Raphaël Giraud (LED - Laboratoire d'Economie Dionysien - Université Paris VIII - Vincennes Saint-Denis)
    Abstract: This paper discusses models of choice under imprecise objective probabilistic information featuring beliefs about beliefs, i.e., second order beliefs. A new model, called second order dual expected utility, featuring nonadditive second order beliefs , is introduced, axiomatized, and systematically contrasted with the leading alternative model of this kind, i.e., the second order subjective expected utility model (Klibanoff et al. 2005, Nau 2006, Seo 2009) for which, for the sake of comparison , we provide a new axiomatization, dispensing with the complex constructs used in extant axiomatizations. Ambiguity attitude and attitude toward information in general are discussed and characterized.
    Keywords: Imprecise probabilistic information,second order beliefs,nonaddi-tive probabilities,ambiguity aversion,Ellsberg paradox,Choquet integral JEL classification D81
    Date: 2014–09–01
  3. By: Guo, Xu; Lien, Donald; Wong, Wing-Keung
    Abstract: To get optimal production and hedging decision with normal random variables, Lien (2008) compares the exponential utility function with its second order approximation. In this paper, we first extend the theory further by comparing the exponential utility function with a n-order approximation for any integer n. We then propose an approach with illustration how to get the least n one could choose to get a good approximation.
    Keywords: Exponential utility, optimal production, hedging, approximation
    JEL: C0 D81 G11
    Date: 2015–09–22
  4. By: Whitle, Richard; Rae, Jonathan; Pyke, Chris
    Abstract: This paper discusses human attitudes towards risk and the development of expected utility models, laying the foundations for the creation of prospect theory in 1979. It proceeds to analyse the decisions of contestants on the popular TV game show Deal or No Deal to attempt to observe any evidence of differing levels of risk aversion under losses and gains as predicted by prospect theory. The results reveal some evidence of decreased risk aversion in the domains of losses and gains, with contestants displaying behaviour consistent with the break-even and house-money effects. We conclude there may be enough evidence of variable reference points to warrant further investigation, and propose suggestions for further research
    Keywords: Decision making under uncertainty, behavioural economics, behavioural finance, biases & heuristics, Prospect Theory.
    JEL: C0 C10 C93
    Date: 2015
  5. By: Nicole B\"auerle; Anna Ja\'skiewicz
    Abstract: This paper studies a one-sector optimal growth model with i.i.d. productivity shocks that are allowed to be unbounded. The utility function is assumed to be non-negative and unbounded from above. The novel feature in our framework is that the agent has risk sensitive preferences in the sense of Hansen and Sargent (1995). Under mild assumptions imposed on the productivity and utility functions we prove that the maximal discounted non-expected utility in the infinite time horizon satisfies the optimality equation and the agent possesses a stationary optimal policy. A new point used in our analysis is an inequality for the so-called associated random variables. We also establish the Euler equation that incorporates the solution to the optimality equation.
    Date: 2015–09
  6. By: Michail Anthropelos; Scott Robertson; Konstantinos Spiliopoulos
    Abstract: We study utility indifference prices and optimal purchasing quantities for a contingent claim, in an incomplete semi-martingale market, in the presence of vanishing hedging errors and/or risk aversion. Assuming that the average indifference price converges to a well defined limit, we prove that optimally taken positions become large in absolute value at a specific rate. We draw motivation from and make connections to Large Deviations theory, and in particular, the celebrated G\"{a}rtner-Ellis theorem. We analyze a series of well studied examples where this limiting behavior occurs, such as fixed markets with vanishing risk aversion, the basis risk model with high correlation, models of large markets with vanishing trading restrictions and the Black-Scholes-Merton model with either vanishing default probabilities or vanishing transaction costs. Lastly, we show that the large claim regime could naturally arise in partial equilibrium models.
    Date: 2015–09
  7. By: Xu Zuo Quan; Zhou Xun Yu; Zhuang Sheng Chao
    Abstract: Bernard et al. (2015) study an optimal insurance design problem where an individual's preference is of the rank-dependent utility (RDU) type, and show that in general an optimal contract covers both large and small losses. However, their contracts suffer from a problem of moral hazard for paying more compensation for a smaller loss. This paper addresses this setback by exogenously imposing the constraint that both the indemnity function and the insured's retention function be increasing with respect to the loss. We characterize the optimal solutions via calculus of variations, and then apply the result to obtain explicitly expressed contracts for problems with Yaari's dual criterion and general RDU. Finally, we use a numerical example to compare the results between ours and that of Bernard et al. (2015).
    Date: 2015–09
  8. By: Antoine Le Riche (AMSE - Aix-Marseille School of Economics - EHESS - École des hautes études en sciences sociales - Centre national de la recherche scientifique (CNRS) - Ecole Centrale Marseille (ECM) - AMU - Aix-Marseille Université, GAINS - University of Maine); Francesco Magris (LEO - François Rabelais University of Tours)
    Abstract: We study an infinite horizon economy with a representative agent whose utility function includes consumption, real balances and leisure. Real balances enter the utility function pre-multiplied by a parameter reflecting the inverse of the degree of financial market imperfection, i.e. the inverse of the transaction costs justifying the introduction of money in the utility function. When labor is supplied elastically, indeterminacy arises through a transcritical and a flip bifurcation, for degree of financial imperfection arbitrarily close to zero. Similar results are observed when labor is supplied inelastically: indeterminacy occurs through a flip bifurcation for values of the degree of financial imperfection unbounded away from zero. We also study the existence and the multiplicity of the steady states.
    Keywords: bifurcations,indeterminacy,market imperfections,money demand
    Date: 2015–09
  9. By: Cook, William; Whittle, Richard
    Abstract: This study seeks to estimate whether individuals’ risk and time preferences are predictive of self employment status and entry. Prior Work: The low risk aversion of those who are self employed is well established in theory and empirical evidence, there is less evidence however on whether risk seeking in existing employees predicts future self employment entry and virtually no empirical research on the links between time preference and self employment. Approach: This study uses a quantitative approach by estimating a series of statistical models that estimate the relationship between an individuals’ risk and time preferences and whether they are (or subsequently become) self employed using a national longitudinal dataset. Results: We find that the self employed are more likely to have low risk aversion. When restricting our analysis to those who are initially employees we find that , low risk aversion combined with a preference for short term gains are most predictive of a transition into self employment. Implications and Value: This study informs the general question as to whether entrepreneurship is linked to personality traits with new evidence on the link between risk and time preference and self employment entry, in doing so it points towards attitudes toward risk and time preference that need to be encouraged if entrepreneurship is to be developed within countries and firms.
    Keywords: Risk Preference, Time Preference, Decision Making, Economics, Entrepreneurship
    JEL: C0 J0 M0
    Date: 2015
  10. By: Koedijk, Kees; Noussair, Charles; Pownall, Rachel A J; Terzi, Ayse
    Abstract: It is well-established that reference points are a feature of decision making under risk. In this paper we report an experiment, in which we investigate which of three potential reference points: (1) a status quo payoff level, (2) the average expected earnings of peers, and (3) a stated expectation of the experimenter, best describes behavior in a decontextualized risky decision making task. We find heterogeneity among individuals in the reference points they employ. The status quo level is the modal reference point, followed by the experimenter's stated expectation of participant earnings, and in turn by the average expected earnings of peers. A sizeable share of individuals show multiple reference points simultaneously. Reference points can be affected by a change in the income level.
    Keywords: experiment; reference point
    Date: 2015–09
  11. By: Raphaël Giraud (LED - Laboratoire d'Economie Dionysien - Université Paris VIII - Vincennes Saint-Denis); Lionel Thomas (CRESE - Centre de REcherches sur les Stratégies Economiques - Université de Franche-Comté)
    Abstract: We investigate the effect of ambiguity and ambiguity attitude on the shape and properties of the optimal contract in an adverse selection model with a continuum of types, using the parametric model of ambiguity and ambiguity aversion called the NEO-additive model (Chateauneuf, Eichberger, and Grant, 2007). We show that it necessarily features efficiency and a jump at the top and pooling at the bottom of the distribution. Conditional on the degree of ambiguity, the pooling section may or may not be supplemented by a separating section. As a result, ambiguity adversely affects the principal’s ability to solve the adverse selection problem and therefore the least efficient types benefit from ambiguity with respect to risk. Conversely, ambiguity is detrimental to the most efficient types. This is confirmed in the comparative statics section.
    Keywords: ambiguity,Adverse selection, ambiguity aversion, NEO-additive model, non-expected utility models, behavioral economics.
    Date: 2015–09–14
  12. By: Arnab Bhattacharjee (Spatial Economics & Econometrics Centre (SEEC), Heriot-Watt University, UK); Robert L. Hicks (College of William and Mary, Williamsburg VA, USA); Kurt E. Schnier (University of California Merced CA, USA)
    Abstract: Agents may consider information and other signals from their peers (especially close peers) when making their spatial site choices. However, the presence of other agents in a spatial location may generate congestion or agglomeration effects. Disentangling the potential peer effects with issues of congestion is difficult since it is hard to ascertain whether the observed congestion effects are a result of observing others behavior or the influence of peer effects within the same network encouraging a fisherman to visit a site even in the presence of congestion. The research develops an empirical framework to decompose both motivations in a spatial discrete choice model in an effort to synthesize the congestion/agglomeration literature with the peer effects literature. Using Monte Carlo analysis we investigate the robustness of our proposed estimation routine to the conventional random utility model (RUM) that ignores both peer and congestion/agglomeration effects as well as the spatial sorting equilibrium model that ignore peer effects. Our results indicate that both the RUM and sorting equilibrium models can be used to successfully investigate the presence of a peer effects. However, the estimates of congestion effects are poor because of ignored correlated random effects. Recent literature has largely used Bayesian methods for this hard problem. We also explore the use of Fixed Effects Multinomial Logit estimates to first estimate the base model, and then extract generalized residuals to estimate the peer effects.
    Date: 2015–09–16
  13. By: Deniz Igan; Marcelo Pinheiro
    Abstract: We analyze the implications of linking the compensation of fund managers to the return of their portfolio relative to that of a benchmark—a common solution to the agency problem in delegated portfolio management. In the presence of such relativeperformance- based objectives, investors have reduced expected utility but markets are typically more informative and deeper. Furthermore, in a multiple asset/market framework we show that (i) relative performance concerns lead to an increase in the correlation between markets (financial contagion); (ii) benchmark inclusion increases price volatility; (iii) home bias emerges as a rational outcome. When information is costly, information acquisition is hindered and this attenuates the effects on informativeness and depth of the market.
    Date: 2015–09–08
  14. By: Karnowahadi Karnowahadi (Department of Business Administration, Semarang Polytechnic State (Polines)); Indah Susilowati (Faculty of Economics and Business, Diponegoro University (UNDIP)); Purbayu Budi Santosa (Faculty of Economics and Business, Diponegoro University (UNDIP))
    Abstract: Surakarta city has various types of cultural heritage, both physical and non-physical, and has a great potential in improving the tourism sector. Surakarta is located at the southern part of Central Java bearing economic functions as a surviving historic city of the country. Despite the great opportunities for cultural heritage in Surakarta, the city is currently facing threats of high traffic, excessive depletion of the natural environment in the city. This is due to underestimation on the market values of cultural heritage indevelopment decisions. Surakarta require an additional source of income for the maintenance and preservation of cultural heritage. The research of willingness to pay (WTP) of the visitor of the Surakarta cultural heritage is needed. Cultural heritage is something that must be preserved, because it is a public good that can carry the name of Surakarta city in the arena of world culture. The aim of this study is to estimate the economic benefit of cultural heritage in Surakarta city as the results would be able to provide insight to the value of this unique heritage society. The methods employed is contingent valuation method (CVM). The payment vehicle opted in this study is via accomodation, where a fixed heritage charge per night was included in the total accomodation bill in Surakarta. In CVM, the logit model was defined based on dichotomous choice method to estimate the WTP randomly with different starting bid value. A total of 225 respondents were interviewed in person, using random stratified sampling method. Utility preservation of cultural heritage Surakarta influenced by several factors, such as gender, age, level of visit frequent, type of work, and the amount of WTP. Gender, age, and type of work affect the utility respondent preservation of Surakarta cultural heritage is a significant positive. Level of visit frequent variable been negatively affect utility. WTP of respondents is greater than the status quo. Variable income, national origin, marital status, and education level influence the utility of Surakarta cultural heritage preservation is not significant. How to withdraw funds for the preservation of Surakarta cultural heritage can be done by adding to the hotel and restaurant taxes, adding to the ticket of admission, or added to the retribution.
    Keywords: economic-valuation, heritage, CVM, Surakarta
  15. By: Céline Guivarch (CIRED); Antonin Pottier (Mines ParisTech)
    Abstract: Recent papers have investigated with Integrated Assessment Models the possibility that climate damages bear on productivity growth and not on production, the traditional route that follows Nordhaus's work. According to these papers, damages on growth lead to a higher social cost of carbon (SCC). Here, we reconsider the evidence with the introduction of a measure of the amount of damages, to allow the comparison between alternative representations of damages. We build a simple climate-economy model and compare three damages specifications: quadratic damages on production, linear damages on growth and quadratic damages on growth. We show that when total damages are the same, the ranking of SCC between a model with damages on production and a model with damages on growth is not unequivocal. It depends on welfare parameters such as the utility discount rate or the elasticity of marginal social utility of consumption. The difference in SCC comes both from when damages occur and from their total amount.
    Keywords: Climate change, damages, social cost of carbon, growth
    JEL: Q54 Q51
    Date: 2015–09
  16. By: Gutiérrez Huerta, María José; Da Rocha, José María; Touza, Julia; García-Cutrín, Javier
    Abstract: International fisheries agencies recommend exploitation paths that satisfy two features. First, for precautionary reasons exploitation paths should avoid high fishing mortality in those fisheries where the biomass is depleted to a degree that jeopardise the stock's capacity to produce the Maximum Sustainable Yield (MSY). Second, for economic and social reasons, captures should be as stable (smooth) as possible over time. In this article we show that a conflict between these two interests may occur when seeking for optimal exploitation paths using age structured bioeconomic approach. Our results show that this conflict be overtaken by using non constant discount factors that value future stocks considering their relative intertemporal scarcity.
    Keywords: fisheries management, optimization in age-structured models, non-constant discount factor, utility function
    Date: 2015

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