nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2016‒04‒30
twenty-one papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Conditional Expected Utility Criteria for Decision Making under Ignorance or Objective Ambiguity By Nicolas Gravel; Thierry Marchant; Arunava Sen
  2. Accommodating Stake Effects under Prospect Theory By Ranoua Bouchouicha; Ferdinand Vieider
  3. Strategic behavior of non-expected utility players in games with payoff uncertainty By Kauffeldt, T. Florian
  4. Recent Developments in the Experimental Elicitation of Time Preference By Cheung, Stephen L.
  5. Solving the Equity Risk Premium Puzzle and Inching Towards a Theory of Everything By Ravi Kashyap
  6. The Impact of Violence on Individual Risk Preferences: Evidence from a Natural Experiment By Jakiela, Pamela; Ozier, Owen
  7. Loyalty and Consumption: A CES representation By INOSE Junya
  8. Optimal investment and consumption with downside risk constraint in jump-diffusion models By Thai Nguyen
  9. Inertia of the U.S. Dollar as a Key Currency through the Two Crises By OGAWA Eiji; MUTO Makoto
  10. Revisiting the tax compliance problem using prospect theory. By Rao, R. Kavita; Tandon, Suranjali
  11. Attitudes toward Flooding Risks in Vietnam: Implications for Insurance By Truong Cong Thanh Nghi
  12. The limits of guilt By Loukas Balafoutas; Helena Fornwagner
  13. Land use change from agriculture to forestry: a structural model of the income and leisure choices of farmers By Ryan, Mary; O'Donoghue, Cathal; Upton, Vincent
  14. Credence Goods, Risk Averse, and Optimal Insurance By Ouyang, Yaofu
  15. The Adverse Consequences of Tournaments: Evidence from a Field Experiment By De Paola, Maria; Gioia, Francesca; Scoppa, Vincenzo
  16. Investing in disaster risk management in an uncertain climate By McDermott,Thomas K.J.
  17. Incentive Contracts and Downside Risk Sharing. By Bernard Sinclair-Desgagné; Sandrine Spaeter
  18. Choosing from multiple alternatives in cost-effectiveness analysis with fuzzy willingness-to-pay/accept and uncertainty By Michal Jakubczyk
  19. Extremists An Experimental Study Of How Social Interactions Change Preferences By Ian Crawford; Donna Harris
  20. Decomposition of Discrete Choice Model Generated Probabilities and their Robustness to Changing Substantive Knowledge (Conditioning Variables) By Dharmasena, Senarath; Bessler, David A.
  21. Uncertainty, rationality and complexity in a multi sectoral dynamic model: the Dynamic Stochastic Generalized Aggregation approach By Michele Catalano; Corrado Di Guilmi

  1. By: Nicolas Gravel (Aix-Marseille University (Aix-Marseille School of Economics), CNRS & EHESS); Thierry Marchant (Ghent University, Department of Data analysis); Arunava Sen (Indian Statistical Institute)
    Abstract: We provide an axiomatic characterization of a family of criteria for ranking completely uncertain and/or ambiguous decisions. A completely uncertain decision is described by the set of all its consequences (assumed to be finite). An ambiguous decision is described as a finite set of possible probability distributions over a finite set of prices. Every criterion in the family compares sets on the basis of their conditional expected utility, for some probability function taking strictly positive values and some utility function both having the universe of alternatives as their domain.
    Keywords: Ignorance, Ambiguity, Conditional Probabilities, Expected Utility, Ranking Sets, axioms
    JEL: D80 D81
    Date: 2016–06–04
  2. By: Ranoua Bouchouicha (Henley Business School, University of Reading); Ferdinand Vieider (Department of Economics, University of Reading)
    Abstract: We investigate how to accommodate qualitative changes in risk preferences over outcomes and probabilities under prospect theory. We find a double two-fold pattern of risk preferences for gains, one over probabilities and one over outcomes. While such patterns over probabilities are an integral part of prospect theory, a solution on how to incorporate two-fold patterns over outcomes has only recently been proposed by Scholten and Read (2014) [‘Prospect theory and the “forgotten” fourfold pattern of risk preferences. JRU 48(1)’]. We use this insight to address violations of probability-outcome separability under prospect theory as stakes increase [Fehr-Duda, Bruhin, Epper, and Schubert (2010). Rationality on the Rise: Why Relative Risk Aversion Increases with Stake Size’. JRU 40(2)]. We replicate the violations using traditional functional forms such as power or exponential utility. Using logarithmic utility instead makes the violations disappear, showing the importance of accommodating changing risk preferences across the outcome dimension.
    Keywords: risk preferences, prospect theory, probability-outcome separability
    JEL: C51 C52 C91 D03 D90
    Date: 2016–04–17
  3. By: Kauffeldt, T. Florian
    Abstract: This paper investigates whether the strategic behavior of expected utility players differs from that of non-expected utility players in the context of incomplete information games where players can choose mixed strategies. Two conditions are identified where uncertainty-averse non-expected utility players behave differently from expected utility players. These conditions concern the use of mixed strategies and the response to it. It is shown that, if and only if these conditions fail, nonexpected utility players behave as if they were expected utility players. The paper provides conditions, in terms of the payoff structure of a game, which are necessary and sufficient for behavioral differences between expected and non-expected utility players. In this context, games are analyzed that are especially relevant for the design of experiments.
    Keywords: Non-expected utility; Incomplete information games;Uncertainty aversion; Mixed strategies; Strategic behavior
    Date: 2016–04–22
  4. By: Cheung, Stephen L. (University of Sydney)
    Abstract: This methodological survey reviews recent developments in the design of experiments to elicit individuals' time preferences, with a focus on the measurement or control for potentially non-linear utility. While the objective of a time preference experiment is usually to estimate parameters of a discount function, assumptions concerning the nature of utility may have an important influence upon these estimates. The survey classifies experiment designs on two dimensions: whether they assume an equivalence between utility under risk and over time, and whether they result in an estimate of the curvature of utility.
    Keywords: time preference, discounted utility, instantaneous utility, choice list
    JEL: C91 D03 D90
    Date: 2016–04
  5. By: Ravi Kashyap
    Abstract: The equity risk premium puzzle is that the return on equities has far exceeded the average return on short-term risk-free debt and cannot be explained by conventional representative-agent consumption based equilibrium models. We review a few attempts to explain this anomaly: 1. Inclusion of highly unlikely events with low probability (Ugly state along with Good and Bad), or market crashes, recently also termed as Black Swans. 2. Slow moving habit added to the basic power utility function. 3. Allowing for a separation of the inter-temporal elasticity of substitution and risk aversion, combined with consumption and dividend growth rates modeled as containing a small persistent expected growth rate component and a fluctuating volatility which captures time varying economic uncertainty. We explore whether a fusion of the above approaches supplemented with better methods to handle the below reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences: 1. Unlimited ability of individuals to invest as compared to their ability to consume. 2. Lack of an objective measuring stick of value which gives rise to heterogeneous preferences and beliefs. 3. Unintended consequences due to the dynamic nature of social systems, where changes can be observed and decisions effected by participants to influence the system. 4. Relaxation of the transversality condition to avoid the formation of asset price bubbles. 5. How durable is durable? Since nothing lasts forever, accounting for durable goods to create a comprehensive measure of consumption volatility. The world we live in produces fascinating phenomenon despite (or perhaps, due to) being a hotchpotch of varying doses of the above elements. The rationale for a unified theory is that beauty can emerge from chaos since the best test for a stew is its taste.
    Date: 2016–04
  6. By: Jakiela, Pamela (University of Maryland); Ozier, Owen (World Bank)
    Abstract: We estimate the impact of Kenya's post-election crisis on individual risk preferences. The crisis interrupted a longitudinal survey of more than five thousand Kenyan youth, creating plausibly exogenous variation in exposure to civil conflict by the time of the survey. We measure individual risk preferences using hypothetical lottery choice questions which we validate by showing that they predict migration and entrepreneurship in the cross-section. Our results indicate that the post-election violence sharply increased individual risk aversion. Immediately after the crisis, the fraction of subjects displaying extreme risk aversion increased by more than 80 percent. Findings remain robust when we use an IV estimation strategy that exploits random assignment of respondents to waves of surveying. Our results suggest that the crisis also impacted trust, social capital, and beliefs about the economy, though it did not have any detectable negative impacts on job prospects or wages.
    Keywords: risk preferences, civil conflict, natural experiment
    JEL: C91 C93 D01 D74 D81
    Date: 2016–04
  7. By: INOSE Junya
    Abstract: This paper offers a new interpretation of the elasticity of substitution in the constant elasticity of substitution (CES) utility function under discrete choice and separability. We model an economy with one discrete choice goods group and one composite good under diverse consumers. The results from our theoretical analysis illustrate the relation between the diversity of loyalty of each good and goods demands. Moreover, the origin of the elasticity of substitution of the CES utility function is described based on our assumptions. According to our results, the power index of the CES utility function does not change even if the diversity of loyalty differs by each good. On the other hand, coefficients of X σ i vary according to each good's attractiveness. We also consider the production under this economy, and find that an increase in productivity leads to a decrease in price. This effect is the same as the standard Melitz model (monopolistic competition).
    Date: 2016–03
  8. By: Thai Nguyen
    Abstract: This paper extends the results of the article [C. Kl\"{u}ppelberg and S. M. Pergamenchtchikov. Optimal consumption and investment with bounded downside risk for power utility functions. In Optimality and Risk: {\it Modern Trends in Mathematical Finance. The Kabanov Festschrift}, pages 133-169, 2009] to a jump-diffusion setting. We show that under the assumption that only positive jumps in the asset prices are allowed, the explicit optimal strategy can be found in the subset of admissible strategies satisfying the same risk constraint as in the pure diffusion setting. When negative jumps probably happen, the regulator should be more conservative. In that case, we suggest to impose on the investor's portfolio a stricter constraint which depends on the probability of having negative jumps in the assets during the whole considered horizon.
    Date: 2016–03
  9. By: OGAWA Eiji; MUTO Makoto
    Abstract: The current international monetary system with the U.S. dollar as a key currency is considered as the background of the U.S. dollar liquidity shortage during the global financial crisis. However, once facing a U.S. dollar liquidity shortage or crisis, financial institutions are likely to avoid their overdependence on the U.S. dollar. This implies that the international monetary system with the U.S. dollar as a key currency may be changed, especially during the global financial crisis even though key currencies show inertia due to network externalities in using international currencies. In this paper, we focus on the effects of both the global financial crisis and the euro zone crisis on the position of the U.S. dollar as a key currency in the current international monetary system. We base this on a theoretical framework in Ogawa and Sasaki (1998) in which a money-in-the-utility model is used to take into account the U.S. dollar's functions as both a medium of exchange and a store of value in the international currency competition. A parameter on the real balance of the U.S. dollar or its contribution to utility in the model is focused on, analyzing empirically whether both the global financial crisis and the euro zone crisis have changed its contribution to utility. One of the main empirical results from our models is that the contribution of the U.S. dollar to utility decreased during the global financial crisis. This corresponds to a period when financial institutions faced liquidity shortages from mid 2007 to late 2008. U.S. dollar liquidity shortage may have decreased the contribution of the U.S. dollar to utility.
    Date: 2016–03
  10. By: Rao, R. Kavita (National Institute of Public Finance and Policy); Tandon, Suranjali (National Institute of Public Finance and Policy)
    Abstract: The paper presents a model for tax compliance based on prospect theory wherein an individual makes the decision whether to file, and declare a certain amount of income, or to not file based on a set of policy parameters as well as his/her preferences. The paper poses the question- at what incomes would individuals choose to file a return and answers the same using a model based on prospect theory. Further, simulations are presented to illustrate the impact of changes in tax rates, penalty and audit probability on the individual's preference to file. The results from the simulation show that for different values of policy parameters there exists crossover income at which individuals would choose to file a return. Given all else, at the exemption threshold of 0.1 million, individuals would choose to file a return at incomes greater than or equal to 0.6 million.
    Keywords: prospect theory ; compliance ; tax ; exemption threshold ; crossover income
    JEL: H26 H31 D11 K42
    Date: 2016–04
  11. By: Truong Cong Thanh Nghi (Faculty of Development Economics, University of Economics Ho Chi Minh City, 1A Hoang Dieu Street, Phu Nhuan District, Ho Chi Minh City)
    Abstract: This study used the experimental method to elicit abstract risk attitudes on and preferences for uncertainties based on the context of flooding in the Mekong Delta, Vietnam. In contrast to the common assumption that farmers are risk averse, our results showed that farmers are, on the average, risk neutral. Moreover, although farmers are ambiguity averse toward Ellsberg-type uncertainty, they are not averse to flooding uncertainty. We also found that farmers systematically underestimate the probability of flooding. The results of the study provide possible explanations for the low take-up of insurance.
    Keywords: Vietnam, Behavioral Economics and social capital, Mitigation, Behavioral/Experimental Economics
    Date: 2016–01
  12. By: Loukas Balafoutas; Helena Fornwagner
    Abstract: Guilt aversion has been put forward in recent years as a prominent motivation for certain aspects of human behavior. When agents are guilt averse, their utility depends on what they believe others expect of them and they suffer a cost whenever they fall short of those expectations. In this paper we suggest that there may be limits to this kind of motivation. We present evidence from a dictator game showing that dictators display behavior consistent with guilt aversion for relatively low levels of recipient expectations, roughly up to the point where the recipient expects half of the available surplus. Beyond that point the relationship between expectations and transfers becomes negative. We argue that this non-monotonicity can help explain why the economic literature on guilt aversion offers conflicting findings on the relationship between expectations and behavior. Moreover, we examine this relationship at the individual level and establish a typology of subjects depending on how and whether they condition their behavior on recipient expectations. Our evidence is consistent with a simple theoretical model of guilt aversion.
    Keywords: guilt aversion, greed, experiment, strategy method
    JEL: C91 D03
    Date: 2016–04
  13. By: Ryan, Mary; O'Donoghue, Cathal; Upton, Vincent
    Abstract: The role of forests in our environment is increasing in importance due to the multifunctional benefits forests provide in relation to climate change mitigation, water conservation and provision of fibre for bioenergy. However, afforestation targets across Europe are not being met. Using Ireland as a case study, we investigate why farm afforestation rates are falling, despite the availability of generous subsidies. We use a novel technique to examine the afforestation participation decision using a life cycle choice framework where we apply revealed choice methodology to afforestation for the first time. We find that the model coefficients coincide with expected economic theory relative to the utility maximisation of income, leisure and wealth (long term land value). However, we observe a cohort of farmers who do not plant forestry regardless of income derived, reflecting their preference to maintain the flexibility of the long term value of their land by continuing to farm.
    Keywords: Afforestation decision, life-cycle analysis, Land Economics/Use, C5, D1, 013.,
    Date: 2015
  14. By: Ouyang, Yaofu
    Abstract: We analyze a credence goods market with risk averse consumers when the assumptions of both liability and verifiability hold. In the basic model, we show that the consumer's risk-aversion would induce expert's overtreatment behavior and thus cause social inefficiency. But the probability of overtreating deceases with the degree of consumer's risk-aversion or the coefficient of absolute risk aversion(CRRA). Furthermore, we extend the basic model with insurance option. We assume there exists a perfectly competitive insurance market where the consumer could purchase insurance. Two sets of equilibria indexed by expert's pricing strategy could be specified. The equilibrium outcome shows that social efficiency could always be achieved and the expert could obtain all the social surplus in the equilibrium.
    Keywords: Credence Goods, Risk Averse, Insurance
    JEL: D81 D82 I11
    Date: 2016–03
  15. By: De Paola, Maria (University of Calabria); Gioia, Francesca (University of Edinburgh); Scoppa, Vincenzo (University of Calabria)
    Abstract: We run a field experiment to investigate whether competing in rank-order tournaments with different prize spreads affects individual performance. Our experiment involved students from an Italian University who took an intermediate exam in which one part was awarded on the basis of their relative performance. Students were matched in pairs on the basis of their high school grades and each pair was randomly assigned to one of three different tournaments. Random assignment neutralizes selection effects and allows us to investigate if larger prize spreads increase individual effort. We do not find any positive effect of larger prizes on students' performance and in several specifications we do find a negative effect. Furthermore, we show that the effect of prize spreads on students' performance depends on their degree of risk-aversion: competing in tournaments with large spreads negatively affects the performance of risk-averse students, while it does not produce any effect on students who are more prone to take risks.
    Keywords: rank-order tournaments, incentives, prize spread, risk-aversion, randomized experiment
    JEL: J33 J31 J24 D81 D82 C93
    Date: 2016–03
  16. By: McDermott,Thomas K.J.
    Abstract: Climate change will exacerbate the challenges associated with environmental conditions, especially weather variability and extremes, in developing countries. These challenges play important, if as yet poorly understood roles in the development prospects of affected regions. As such, climate change reinforces the development case for investment in disaster risk management. Uncertainty about how climate change will affect particular locations makes optimal investment planning more difficult. In particular, the inability to derive meaningful probabilities from climate models limits the usefulness of standard project evaluation techniques, such as cost-benefit analysis. Although the deep uncertainty associated with climate change complicates disaster risk management investment decisions, the analysis presented here shows that these considerations are only relevant for a relatively limited set of investment circumstances. The paper offers a simple decision framework that enables policy makers to identify the particular circumstances under which uncertainty about future climate change becomes critical for disaster risk management investment decisions. Accounting for climate uncertainty is likely to shift the optimal balance of disaster risk management strategies toward more flexible, low-regret type interventions, especially those that seek to promote"development first"or"risk-coping"objectives. Such investments are likely to confer additional development dividends, regardless of the climate future that materializes in a given location. Importantly, the analysis here also demonstrates that climate uncertainty does not necessarily motivate a"wait and see"approach. Instead, where opportunities exist to avail of adaptation co-benefits, climate uncertainty provides additional motivation for early investment in disaster risk management initiatives.
    Keywords: Adaptation to Climate Change,Climate Change Economics,Science of Climate Change,Economic Theory&Research,Climate Change Mitigation and Green House Gases
    Date: 2016–04–12
  17. By: Bernard Sinclair-Desgagné; Sandrine Spaeter
    Abstract: This paper seeks to characterize incentive compensation in a principal-agent moral hazard setting in which the principal is prudent, or downside risk averse, as many situations (such as that of a patient in hospital or a regulator dealing with food safety) suggest she should be. We show that optimal incentive pay should then be 'approximately concave' in performance, the approximation being closer the more downside risk averse the principal is compared to the agent. Limiting the agent's liability would improve the approximation, but taxing the principal would make it coarser. The notion of an approximately concave function we introduce here to describe the pay-performance relationship is relatively recent in mathematics; it is intuitive and translates into concrete empirical implications, notably for the composition of incentive pay. We also clarify which measure of prudence - among the various ones proposed in the literature - is relevant to investigate the tradeoff between downside risk sharing and incentives.
    Keywords: Pay-performance relationship; executive compensation; downside risk aversion; approximate concavity.
    JEL: D82 M12 M52
    Date: 2016
  18. By: Michal Jakubczyk
    Abstract: Cost-effectiveness analysis of medical technologies requires valuing health, an uneasy task, as confirmed by variability of published estimates. Treating the willingness-to-pay/accept (WTP/WTA) as fuzzy seems an intuitive solution. Based on this premise, I construct a framework allowing to compare multiple health technologies using choice functions. The final choice must be crisp, so I discuss various defuzzification methods and show that using indecisiveness point (IP) for WTP/WTA (the value the decision maker equally approves/disapproves) has desirable properties: satisfying the independence of irrelevant alternatives and not treating the Likert scale as interval. I suggest three approaches to infer about IP with Likert-based surveys in random samples (hypothesis testing, Bayesian or frequentist estimation). No difference between IPs for WTP/WTA is found, and an explanation of the WTP-WTA disparity is provided. Estimating IP results in stochastic uncertainty, and I show how to conduct sensitivity analysis in the framework and what new insight is gained.
    Keywords: Willingness-to-pay/accept, Fuzzy sets, Preference elicitation, Cost-effectiveness analysis, Sensitivity analysis
    JEL: C44 C13 D81 D61
    Date: 2016–04
  19. By: Ian Crawford; Donna Harris
    Abstract: Abstract: We study the effects of social interactions on individuals’ other-regarding preferences. Using a modified dictator game and a structural choice-revealed preference approach, we compare five models of other regarding preferences and, using our preferred specification, we measure an individual’s preferences before and after subjects have interacted face-to-face in a small group. We then examine whether a change in preferences is observed. We find that these interactions do indeed change individuals’ other-regarding preferences and that these effects are highly heterogeneous. In most groups, preferences of individual group members become more homogenous as might be expected, but we also find that subjects’ preferences can converge towards those of a single key individual in the group whose preferences are both extreme and also unchanging. These key individuals often have strongly egoistic preferences and are also more likely to be male. These effects are more prevalent amongst younger subjects than older.
    Keywords: Other-regarding preferences, social interactions, preference dynamics, preference heterogeneity, social conformity
    JEL: C90 C92 D70
    Date: 2016–03–29
  20. By: Dharmasena, Senarath; Bessler, David A.
    Abstract: Clear understanding of “goodness” and how substantive knowledge contributes to such goodness is generally absent from the economist’s use of probability. Although probability forecast from either subjective experts or from data based on prior theory and models can be generated, it is more problematic to generate a “good probability forecast” with a crisp understanding of what constitutes “good”. Further it is generally not clear to economists how different conditioning information affects this measure of “good.” Heretofore probability forecasts have been evaluated using the Brier Score and its Yates partition. Our work contributes by exploring how different sets of substantive information affect the Brier score and each component of the Yates partition. We will explore partitions associated with a set of observational data on beverages and the associated consumer decision to purchase. Probabilities are modeled using discrete choice models. Results show the higher the substantive knowledge, higher the model’s ability to offer a high probability for events occurred versus low probability for events that did not occur. Also, this model gave rise to lower Brier Score (lower the better) and higher covariance between probabilities offered and events observed. Better sorting of probabilities was demonstrated in the model with more substantive knowledge.
    Keywords: Brier Score, Yates partition, probabilities, discrete choice model, beverages, Consumer/Household Economics, Research Methods/ Statistical Methods, C18,
    Date: 2016–02
  21. By: Michele Catalano; Corrado Di Guilmi
    Abstract: The paper proposes an innovative approach for the analytical solution of agent-based models. The approach is termed Dynamic Stochastic Generalized Aggregation (DSG-A) and is tested on a macroeconomic model articulated in a job and in a goods markets with a large number of heterogeneous and interacting agents (namely firms and workers). The agents heuristically adapt their expectations by interpreting the signals from the market and give rise to macroeconomic regularities. The model is analytically solved in two different scenarios. In the first, the emergent proper- ties of the system are determined uniquely by the myopic behavior of the agents while, in the second, a social planner quantifies the optimal number of agents adopting a particular strategy. The integration of the DSG-A approach with intertemporal optimal control allows the identification of multiple equilibria and their qualitative classification.
    Keywords: aggregation, uncertainty, opinion dynamics, master equation, optimal control
    JEL: C61 E32
    Date: 2016–04

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