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on Utility Models and Prospect Theory |
| By: | Charles F. Manski; Aleksey Tetenov |
| Abstract: | Medical research has evolved conventions for choosing sample size in randomized clinical trials that rest on the theory of hypothesis testing. Bayesians have argued that trials should be designed to maximize subjective expected utility in settings of clinical interest. This perspective is compelling given a credible prior distribution on treatment response, but Bayesians have struggled to provide guidance on specification of priors. We use the frequentist statistical decision theory of Wald (1950) to study design of trials under ambiguity. We show that epsilon-optimal rules exist when trials have large enough sample size. An epsilon-optimal rule has expected welfare within epsilon of the welfare of the best treatment in every state of nature. Equivalently, it has maximum regret no larger than epsilon. We consider trials that draw predetermined numbers of subjects at random within groups stratified by covariates and treatments. The principal analytical findings are simple sufficient conditions on sample sizes that ensure existence of epsilon-optimal treatment rules when outcomes are bounded. These conditions are obtained by application of Hoeffding (1963) large deviations inequalities to evaluate the performance of empirical success rules. |
| JEL: | C90 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:cca:wpaper:430&r=all |
| By: | Gadi S. Perets (Université de Lyon, Lyon (University of Lyon)); Eran Yashiv (Pinhas Sapir Center for Economic Development Eitan Berglas School of Economics Tel Aviv University; Centre for Macroeconomics (CFM)) |
| Abstract: | Many models in Economics assume a utility function belonging to the HARA family. This paper shows that HARA utility is more fundamental to economic analysis. The HARA functional form is the unique form which satisfies basic economic principles in an optimization context. Using HARA is therefore not just a matter of convenience or tractability but rather emerges from economic reasoning, i.e., it is inherent in the economic optimization problem. The paper applies Lie symmetries to the optimality equation of Merton’s (1969, 1971) widely used intertemporal model of the consumer-investor in order to show the inherent nature of the HARA utility function. Lie symmetries derive the conditions whereby the optimal solution remains invariant under scale transformations of wealth. The latter arise as the result of growth over time or due to the effects of policy. The symmetries place restrictions on the model, with the key one being the use of HARA utility. We show that this scale invariance of agents’ wealth implies linear optimal solutions to consumption and portfolio allocation and linear risk tolerance (and vice versa). The results have broad implications, as the model studied is a fundamental one in Macroeconomics and Finance. The paper demonstrates the use of Lie symmetries as a powerful tool to deal with economic optimization problems. |
| Keywords: | HARA utility, invariance, economic optomization, consumption and portfolio choice, macroeconomics, finance, Lie Symmetries |
| JEL: | D01 D11 D91 E21 G11 C60 |
| Date: | 2015–09 |
| URL: | http://d.repec.org/n?u=RePEc:cfm:wpaper:1522&r=all |
| By: | Massimiliano AMARANTE; Mario GHOSSOUB; Edmund PHELPS |
| Abstract: | Empirical evidence suggests that ambiguity is prevalent in insurance pricing and underwriting, and that often insurers tend to exhibit more ambiguity than the insured individuals (e.g., [23]). Motivated by these findings, we consider a problem of demand for insurance indemnity schedules, where the insurer has ambiguous beliefs about the realizations of the insurable loss, whereas the insured is an expected-utility maximizer. We show that if the ambiguous beliefs of the insurer satisfy a property of compatibility with the non-ambiguous beliefs of the insured, then there exist optimal monotonic indemnity schedules. By virtue of monotonicity, no ex-post moral hazard issues arise at our solutions (e.g., [25]). In addition, in the case where the insurer is either ambiguity-seeking or ambiguity-averse, we show that the problem of determining the optimal indemnity schedule reduces to that of solving an auxiliary problem that is simpler than the original one in that it does not involve ambiguity. Finally, under additional assumptions, we give an explicit characterization of the optimal indemnity schedule for the insured, and we show how our results naturally extend the classical result of Arrow [5] on the optimality of the deductible indemnity schedule. |
| Keywords: | optimal insurance, deductible, ambiguity, choquet integral, distorted probabilities |
| JEL: | G22 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:mtl:montec:04-2015&r=all |
| By: | Hee Su Roh; Yinyu Ye |
| Abstract: | Pari-mutuel markets are trading platforms through which the common market maker simultaneously clears multiple contingent claims markets. This market has several distinctive properties that began attracting the attention of the financial industry in the 2000s. For example, the platform aggregates liquidity from the individual contingent claims market into the common pool while shielding the market maker from potential financial loss. The contribution of this paper is two-fold. First, we provide a new economic interpretation of the market-clearing strategy of a pari-mutuel market that is well known in the literature. The pari-mutuel auctioneer is shown to be equivalent to the market maker with extreme ambiguity aversion for the future contingent event. Second, based on this theoretical understanding, we present a new market-clearing algorithm called the Knightian Pari-mutuel Mechanism (KPM). The KPM retains many interesting properties of pari-mutuel markets while explicitly controlling for the market maker's ambiguity aversion. In addition, the KPM is computationally efficient in that it is solvable in polynomial time. |
| Date: | 2015–09 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1509.07155&r=all |
| By: | Antoine Le Riche (GAINS, Aix-Marseille University (Aix-Marseille School of Economics), GREQAM, CNRS & EHESS); Francesco Magris (LEO, University “François Rabelais” 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: | 2015–09–11 |
| URL: | http://d.repec.org/n?u=RePEc:aim:wpaimx:1535&r=all |
| By: | Christos Genakos; Costas Roumanias; Tommaso Valletti |
| Abstract: | We analyze consumer switching between mobile tariff plans using consumer-level panel data. Consumers receive reminders from a specialist price-comparison website about the precise amount they could save by switching to alternative plans. We find that the effect on switching of being informed about potential savings is positive and significant. Controlling for savings, we also find that the effect of incurring overage payments is also significant and six times larger in magnitude. Paying an amount that exceeds the recurrent monthly fee weighs more on the switching decision than being informed that one can save that same amount by switching to a less inclusive plan, implying that avoidance of losses motivates switching more than the realization of equal-sized gains. We interpret this as evidence of loss aversion. We are also able to weigh how considerations of risk versus loss aversion affect mobile tariff plan choices: we find that a uniform attitude towards risk in both losses and gains has no significant influence on predicting consumers' switching, whereas perceiving potential savings as avoidance of losses, rather than as gains, has a strong and positive effect. |
| Keywords: | Loss aversion, consumer switching, tariff plans, risk aversion, mobile telephony |
| JEL: | D03 D12 D81 L96 |
| Date: | 2015–09 |
| URL: | http://d.repec.org/n?u=RePEc:cep:cepdps:dp1373&r=all |
| By: | Hande Kucuk; Alan Sutherland |
| Abstract: | This paper aims to account for the Backus-Smith puzzle in a generally calibrated two-country DSGE model with endogenous portfolio choice in international bonds and equities. There are multiple shocks, including shocks to TFP, labour supply, investment, government spending and monetary policy. Hence, there are more risks than can be spanned by international trade in equities and bonds, i.e. markets are incomplete. The utility function in the benchmark model is non-separable in consumption and leisure and there is external habit formation in consumption. We compare the benchmark model with models that differ according to preference/habit specification and financial market structure. We find that the benchmark model with non-separable preferences across consumption and leisure, habit formation and incomplete financial markets implies almost zero correlation between relative consumption and the real exchange rate while generating bond and equity portfolios that are broadly in line with the data. What is more, the cross-country correlation of consumption is lower than the cross-country correlation of output in our benchmark model, which has proved to be a difficult fact to match in IRBC models. Non-separable preferences are found to be crucial to generating these results but financial market structure plays only a minor role. |
| Keywords: | Portfolio choice, International risk sharing, Consumption-real exchange rate anomaly, Backus-Smith puzzle, Non separable preferences, Incomplete markets |
| JEL: | F31 F41 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:tcb:wpaper:1517&r=all |
| By: | Akgüc, Mehtap (Center for European Policy Studies (CEPS)); Liu, Xingfei (Ryerson University); Tani, Massimiliano (IZA); Zimmermann, Klaus F. (IZA and University of Bonn) |
| Abstract: | To contribute to a scarce literature, in particular for developing and emerging economies, we study the nature of measured risk attitudes and their consequences for migration. We also investigate whether substantial changes in the risk environment influences risk tolerance. Using the 2009 RUMiC data for China, we find that rural-urban migrants and their family members are substantially less risk-averse than stayers. We further provide evidence that individual risk attitudes are unaffected by substantial changes in the environment and that risk tolerance is correlated across generations. |
| Keywords: | risk aversion, risk attitudes, migration, China |
| JEL: | J61 D81 |
| Date: | 2015–09 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp9347&r=all |
| By: | John Mullahy |
| Abstract: | Models having multivariate probit and related structures arise often in applied health economics. When the outcome dimensions of such models are large, however, estimation can be challenging owing to numerical computation constraints and/or speed. This paper suggests the utility of estimating multivariate probit (MVP) models using a chain of bivariate probit estimators. The proposed approach offers two potential advantages over standard multivariate probit estimation procedures: significant reductions in computation time; and essentially unlimited dimensionality of the outcome set. The time savings arise because the proposed approach does not rely simulation methods; the dimension advantage arises because only pairs of outcomes are considered at each estimation stage. Importantly, the proposed approach provides a consistent estimator of all the MVP model's parameters under the same assumptions required for consistent estimation based on standard methods, and simulation exercises suggest no loss of estimator precision. |
| JEL: | C3 I1 |
| Date: | 2015–09 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:21593&r=all |
| By: | Jonas Nygaard Eriksen (Aarhus University and CREATES) |
| Abstract: | This paper studies the predictability of bond risk premia by means of expectations to future business conditions using survey forecasts from the Survey of Professional Forecasters. We show that expected business conditions consistently affect excess bond returns and that the inclusion of expected business conditions in standard predictive regressions improve forecast performance relative to models using information derived from the current term structure or macroeconomic variables. The results are confirmed in a real-time out-of-sample exercise, where the predictive accuracy of the models is evaluated both statistically and from the perspective of a mean-variance investor that trades in the bond market. |
| Keywords: | Bond risk premia, expected business conditions, predictability, economic value, expectations hypothesis, time-varying risk premia |
| JEL: | E43 E44 E47 G11 G12 |
| Date: | 2015–09–24 |
| URL: | http://d.repec.org/n?u=RePEc:aah:create:2015-44&r=all |
| By: | Federico Fornasari; Matteo Ploner; Ivan Soraperra |
| Abstract: | We investigate investment in risk protection when risk affects either the decision maker or another individual and when the cost to offset risk is borne either by the decision maker or by another individual. We assess be- havior in the experiment against predictions obtained from a well-known social preferences model. In line with our predictions, we find that in- dividuals invest more of others’ resources than of their own resources to protect themselves, and individuals invest more of their own resources in risk protection when risk is borne by themselves than when risk is borne by the others. Furthermore, individuals invest more in risk protection when delegated to choose for others than when choosing for themselves. |
| Keywords: | social preferences; risk; laboratory experiments; delegated choice |
| JEL: | C91 D03 D80 O12 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:trn:utwpce:1503&r=all |
| By: | Roberto Marfè |
| Abstract: | This paper empirically and theoretically investigates the relation between labor rigidity and the value premium. Aggregate labor rigidity shifts dividend risk towards the short horizon and enhances the pricing of short-run risk. In turn, shorter duration equity deserves a premium over longer duration equity, that is the value premium obtains. Con- sistently, labor-share variation strongly explains the contemporaneous and intertemporal excess return of value firms over growth firms. A closed-form general equilibrium model reproduces the term-structure effect of labor rigidity and naturally gives rise to the value premium and its dynamics. The model is robust to many features of financial markets. |
| Keywords: | value premium, labor rigidity, term-structure, predictability, duration |
| JEL: | D51 E21 G12 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:cca:wpaper:429&r=all |
| By: | Naef, Michael; Sontuoso, Alessandro |
| Abstract: | We examine a novel class of conformist preferences which falls within the realm of belief-dependent motivations in that the peers’ expectations about others’ behavior may affect every group-member’s welfare. Similar other-regarding motivations, like guilt-aversion, have been inferred from evidence of a belief-behavior correlation but the issue of causality has been disputed. In examining conformism we propose a design that verifies the presence of the relevant causality direction while ruling out alternative other-regarding motivations. Our data reveal “self-servingly conformist” behavior in that subjects choose to match their strategy to the peers’ expectations when it is in their interest to do so. |
| Keywords: | conformist preferences, consensus effects, belief-dependent utility, guilt aversion, social norms, trust |
| JEL: | C72 C91 |
| Date: | 2015–09–13 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:66965&r=all |
| By: | Strand,Jon; Siddiqui,Sauleh |
| Abstract: | What is the utility from obtaining more precise values of natural resource objects (rainforests), through surveys or other similar information gathering? In the value of information problems studied here, a principal who wishes to preserve a resource sets a price to offer to a seller without knowing precisely the protection value or opportunity value, to the seller. The value of information related to more precise information about the protection value for the principal is a key issue in environmental and natural resource valuation, but it is in most cases implicit and not analyzed. More precise resource values reduce the frequency of two types of mistakes (saving the resource when it should not be saved, and not saving the resource when it should be saved), and increases the principal?s ex ante expected utility value. This paper applies the model to Amazon rainforest protection and considers the hypothetical value of perfect information. The analysis finds that the value of perfect information can easily exceed realistic information costs, thus perhaps justifying significant expenditures for valuation studies, given that all available information is used efficiently for conservation decision purposes. The value of perfect information also depends on the nature of buyer-seller interactions, and is higher in the altruistic case, where the principal has full concern for the outcome for the seller. |
| Keywords: | Economic Theory&Research,Labor Policies,Information and Communication Technologies,Environmental Economics&Policies |
| Date: | 2015–09–28 |
| URL: | http://d.repec.org/n?u=RePEc:wbk:wbrwps:7423&r=all |