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on Utility Models and Prospect Theory |
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Issue of 2016‒09‒18
eighteen papers chosen by |
| By: | Victor H. Aguiar (University of Western Ontario) |
| Abstract: | In this study we introduce a new stochastic choice rule that categorizes objects in order to simplify the choice procedure. At any given trial, the decision maker deliberately randomizes over mental categories and chooses the best item according to her utility function within the realized consideration set formed by the intersection of the mental category and the menu of alternatives. If no alternative is present both within the considered mental category and within the menu the decision maker picks the default option. We provide the necessary and sufficient conditions that characterize this model in a complete stochastic choice dataset in the form of an acyclicicity restriction on a stochastic choice revealed preference and other regularity conditions. We recover the utility function uniquely up to a monotone transformation and the probability distribution over mental categories uniquely. This model is able to accommodate violations of IIA (independence of irrelevant alternatives), of stochastic transitivity, and of the Manzini-Mariotti menu independence notion (i-Independence). A generalization of the categorizing procedure accommodates violations of regularity and thus provides an alternative model to random utility. |
| Keywords: | Decision Theory; Random Choice; Bounded Rationality; Categorization; Consideration Sets |
| JEL: | C60 D10 |
| Date: | 2016 |
| URL: | http://d.repec.org/n?u=RePEc:uwo:uwowop:20163&r=upt |
| By: | David B. Johnson (Department of Economics, Finance, and Marketing, University of Central Missouri); Matthew D. Webb (Department of Economics, Carleton University) |
| Abstract: | Little is known about how individuals make decisions when they must choose several options from a set of options when the outcomes are risky and the payoffs are rival. When researchers model these decisions, they assume people maximize their expected utility. We design an experiment in which subjects face either rival or independent payoffs. While theory predicts different behavior, subjects behave nearly identically under these payoff schemes. This suggests individuals are not maximizing expected utility. Additional treatments demonstrate that this behavior is likely driven by a heuristic used to simplify a complex math problem, rather than a preference for lotteries with the highest independent expected utilities. Our results suggest that using expected utility as peoples' objective function in these types of environments will lead to biased predictions. |
| Keywords: | decision making, risk, rival, online experiment |
| JEL: | C90 D01 D81 |
| Date: | 2016–09–18 |
| URL: | http://d.repec.org/n?u=RePEc:car:carecp:16-12&r=upt |
| By: | Dominique Pepin (CRIEF - Centre de Recherche sur l'Intégration Economique et Financière - Université de Poitiers) |
| Abstract: | By analysing the restrictions that ensure the existence of capital market equilibrium, we show that the coefficient of relative risk aversion and the subjective discount factor cannot be high simultaneously as they are supposed to be to make the standard asset pricing consistent with financial stylised facts. |
| Keywords: | subjective discount factor,risk aversion,asset prices,equilibrium,risk premium |
| Date: | 2016–06 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-01299834&r=upt |
| By: | Sheremeta, Roman |
| Abstract: | Researchers have proposed various theories to explain overbidding in rent-seeking contents, including mistakes, systematic biases, the utility of winning, and relative payoff maximization. Through an eight-part experiment, we test and find significant support for the existing theories. Also, we discover some new explanations based on cognitive ability and impulsive behavior. Out of all explanations examined, we find that impulsivity is the most important factor explaining overbidding in contests. |
| Keywords: | rent-seeking, contest, competition, impulsive behavior, experiments |
| JEL: | C72 C91 D01 D72 |
| Date: | 2016–09–14 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:73731&r=upt |
| By: | Stephen J. Redding; David E. Weinstein |
| Abstract: | The measurement of price changes, economic welfare, and demand parameters is currently based on three disjoint approaches: macroeconomic models derived from time-invariant utility functions, microeconomic estimation based on time-varying utility (demand) systems, and actual price and real output data constructed using formulas that differ from either approach. The inconsistencies are so deep that the same assumptions that form the foundation of demand-system estimation can be used to prove that standard price indexes are incorrect, and the assumptions underlying standard exact and superlative price indexes invalidate demand-system estimation. In other words, we show that extant micro and macro welfare estimates are biased and inconsistent with each other as well as the data. We develop a unified approach to demand and price measurement that exactly rationalizes observed micro data on prices and expenditure shares while permitting exact aggregation and meaningful macro comparisons of welfare over time. We show that all standard price indexes are special cases of our approach for particular values of the elasticity of substitution, constant preferences for each good, and a constant set of goods. In contrast to these standard index numbers, our approach allows us to compute changes in the cost of living that take into account both changes in the preferences for individual goods and the entry and exit of goods over time. Using barcode data for the U.S. consumer goods industry, we show that allowing for the entry and exit of products, changing preferences for individual goods, and a value for the elasticity of substitution estimated from the data yields substantially different conclusions for changes in the cost of living from standard index numbers. |
| Keywords: | elasticity of substitution; price index; consumer valuation bias; new goods; welfare |
| JEL: | D11 D12 E01 E31 |
| Date: | 2016–08 |
| URL: | http://d.repec.org/n?u=RePEc:ehl:lserod:67681&r=upt |
| By: | Davis, John B. (Department of Economics Marquette University) |
| Abstract: | This paper examines Geoff Hodgson’s interpretation of Veblen in agency-structure terms, and argues it produces a conception of reflexive economic agents. It then sets out an account of cumulative causation processes using this reflexive agent conception, modeling them as a two-part causal process, one part involving a linear causal relation and one part involving a circular causal relation. The paper compares the reflexive agent conception to the standard expected utility conception of economic agents, and argues that on a cumulative causation view of the world the completeness assumption essential to the standard view of rationality cannot be applied. The final discussion addresses the nature of the choice behavior of reflexive economic agents, using the thinking of Amartya Sen and Herbert Simon to frame how agents might approach choice in regard to each of the two different parts of cumulative causal processes, and closing with brief comments on behavioral economics’ understanding of reference dependence and position adjustment. |
| Keywords: | Hodgson, Veblen, cumulative causation, reflexive agents, completeness assumption |
| JEL: | B41 B52 D01 |
| Date: | 2016–08 |
| URL: | http://d.repec.org/n?u=RePEc:mrq:wpaper:2016-05&r=upt |
| By: | Soetevent, Adriaan R.; Bruzikas, Tadas (Groningen University) |
| Date: | 2016 |
| URL: | http://d.repec.org/n?u=RePEc:gro:rugsom:16015-eef&r=upt |
| By: | Brice Corgnet (EMLYON Business School, Univ Lyon, GATE L-SE UMR 5824, F-69131 Ecully, France); Joaquín Gómez-Miñambres (Bucknell University, Department of Economics, One Dent Drive, Lewisburg, PA 17837. Chapman University, Economic Science Institute. One University Drive, Orange, California 92866); Roberto Hernán-Gonzalez (Nottingham University, Business School, Nottingham, UK) |
| Abstract: | We study a principal-agent framework in which principals can assign wage-irrelevant goals to agents. We find evidence that, when given the possibility to set wage-irrelevant goals, principals select incentive contracts for which pay is less responsive to agents’ performance. We show that average performance of agents is higher in the presence of goal setting than in its absence despite weaker incentives. We develop a principal-agent model with reference-dependent utility that illustrates how labor contracts combining weak monetary incentives and wage-irrelevant goals can be optimal. It follows that recognizing the pervasive use of non-monetary incentives in the workplace may help account for previous empirical findings suggesting that firms rely on unexpectedly weak monetary incentives. |
| Keywords: | Principal-agent models, incentive theory, non-monetary incentives, goal setting, reference-dependent utility, laboratory experiments |
| JEL: | C92 D23 M54 |
| Date: | 2016 |
| URL: | http://d.repec.org/n?u=RePEc:gat:wpaper:1628&r=upt |
| By: | Ravi Bansal (Duke University); Hengjie Ai (University of Minnesota) |
| Abstract: | Empirical evidence shows that a large fraction of equity premium is realized on a relatively small number of trading days with significant macroeconomic news announcements. In the 1961-2014 period, for example, about 55% of the entire equity premium is earned on about 30 trading days per year with significant macroeconomic announcements. In addition, the market equity premium typically rises prior to the announcement and falls immediately afterwards. In this paper, we develop an abstract theory and a quantitative model for the equity premium associated with macroeconomic news announcements. We demonstrate that the announcement premium identifies the compensation for investors’ uncertainty aversion on capital markets. We present a dynamic model to account for the evolution of equity premium around macroeconomic announcements. |
| Date: | 2016 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed016:715&r=upt |
| By: | Frank N. Caliendo; Maria Casanova; Aspen Gorry; Sita Slavov |
| Abstract: | Uncertainty about the timing of retirement is a major financial risk with implications for decision making and welfare over the life cycle. Our conservative estimates of the standard deviation of the difference between retirement expectations and actual retirement dates range from 4.28 to 6.92 years. This uncertainty implies large fluctuations in total wage income. We find that individuals would give up 2.6%-5.7% of total lifetime consumption to fully insure this risk and 1.9%-4.0% of lifetime consumption simply to know their actual retirement date at age 23. Uncertainty about the date of retirement helps to explain consumption spending near retirement and precautionary saving behavior. While social insurance programs could be designed to hedge this risk, current programs in the U.S. (OASI and SSDI) provide very little timing insurance. |
| JEL: | C61 E21 H55 J26 |
| Date: | 2016–09 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:22609&r=upt |
| By: | Francis Larson; John A. List; Robert D. Metcalfe |
| Abstract: | Behavioral economists have recently put forth a theoretical explanation for the equity premium puzzle based on combining myopia and loss aversion. Complementing the behavioral theory is evidence from laboratory experiments, which provide strong empirical support consistent with myopic loss aversion (MLA). Yet, whether, and to what extent, such preferences underlie behaviors of traders in their natural domain remains unknown. Indeed, a necessary condition for the MLA theory to explain the equity premium puzzle is for marginal traders in markets to exhibit such preferences. Using minute-by-minute trading observations from over 864,000 price realizations in a natural field experiment, we find data patterns consonant with MLA: in their normal course of business, professional traders who receive infrequent price information invest 33% more in risky assets, yielding profits that are 53% higher, compared to traders who receive frequent price information. Beyond testing theory, these results have important implications for efficient resource allocation as well as characterizing the optimal structure of social and economic policies. |
| JEL: | C9 C93 G02 G11 |
| Date: | 2016–09 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:22605&r=upt |
| By: | Daniela Di Cagno (LUISS, Rome); Werner Gürth (LUISS, Rome; Max Planck Institute for Research on Collective Goods, Bonn; Frankfurt Business School); Noemi Pace (Ca’ Foscari University of Venice, Department of Economics; LUISS, Rome); Francesca Marzo (LUISS, Rome) |
| Abstract: | A risky choice experiment is based on one-dimensional choice variables and risk neutrality induced via binary lottery incentives. Each participant confronts many parameter constellations with varying optimal payoffs. We assess (sub)optimality, as well as (non)optimal satisficing, partly by eliciting aspirations in addition to choices. Treatments differ in the probability that a binary random event, which are payoff- but not optimal choice–relevant, is experimentally induced and whether participants choose portfolios directly or via satisficing, i.e., by forming aspirations and checking for satisficing before making their choice. By incentivizing aspiration formation, we can test satisficing, and in cases of satisficing, determine whether it is optimal. |
| Keywords: | (un)Bounded Rationality, Satisficing, Risk, Uncertainty, Experiments |
| JEL: | D03 D81 C91 |
| Date: | 2016 |
| URL: | http://d.repec.org/n?u=RePEc:ven:wpaper:2016:22&r=upt |
| By: | Dezső, Linda; Steinhart, Jonathan; Bakó, Barna; Kirchler, Erich |
| Abstract: | Focusing illusion describes how, when making choices, people may put disproportionate attention on certain attributes of the options and hence, causing those options to be overvalued. For instance, in deciding whether or not to take out a loan, people may focus more on getting the loan than on its small and dispersed costs. Building on recent literature on focusing illusion in economic choice, we theoretically propose and empirically test that focusing illusion can be advantageously exploited such that attention is put back on the ignored attributes. To demonstrate this, we use hypothetical loan decisions where people choose between loans with different repayment plans to finance a purchase. We show that when adding a steeply decreasing-installments plan to the original choice set of not borrowing or borrowing under a fixed-installments plan, the preference for the fixed-installments plan is lessened. This is because preference for the fixed-installments plan shifted towards not borrowing. We discuss potential applications of our results in designing choice sets of intertemporal sequences. |
| Keywords: | focusing illusion, focus-weighted utility, loan decisions, intertemporal choice |
| JEL: | D03 D91 |
| Date: | 2016–08–18 |
| URL: | http://d.repec.org/n?u=RePEc:cvh:coecwp:2016/11&r=upt |
| By: | Martin M. Andreasen (Aarhus University and CREATES); Tom Engsted (Aarhus University and CREATES); Stig V. Møller (Aarhus University and CREATES); Magnus Sander (Aarhus University and CREATES) |
| Abstract: | This paper provides new evidence on bond risk premia by conditioning the classic Campbell-Shiller regressions on the business cycle. In expansions, we find mostly positive intercepts and negative regression slopes, but the results are completely reversed in recessions with negative intercepts and positive regression slopes. We reproduce these coefficients in a term structure model with business cycle dependent loadings in the market price of risk. This model also predicts excess returns in the right direction during expansions and recessions, whereas the Gaussian affine term structure model predicts excess returns for medium- and long-term bonds with the wrong sign during recessions. |
| Keywords: | Bond return predictability, Business cycle variation in excess returns, Market price of risk, Zero-lower bound, Unspanned macroeconomic risk. |
| JEL: | E43 E44 G12 |
| Date: | 2016–08–30 |
| URL: | http://d.repec.org/n?u=RePEc:aah:create:2016-26&r=upt |
| By: | Pierlauro Lopez (Banque de France) |
| Abstract: | The welfare cost of economic uncertainty has a term structure that is a simple transformation of the term structures of the equity premium and interest rates. Twenty years of financial market data suggest a term structure of welfare costs that is downward-sloping on average and during downturns. This evidence offers guidance in selecting a model to study the benefits of greater consumption stability from a structural perspective. A model with nominal rigidities and nonlinear external habits can rationalize the evidence and motivates the competitive level and volatility of consumption as inefficient. The model is observationally equivalent to a standard New Keynesian model with CRRA utility but the optimal policy prescription is overturned; in the model the central bank should focus on removing consumption volatility rather than on filling the gap between consumption and its flexible-price counterpart. |
| Date: | 2016 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed016:742&r=upt |
| By: | Lee, Seungduck |
| Abstract: | This paper examines the effect of monetary policy on the liquidity premium, i.e., the market value of the liquidity services that financial assets provide. To guide the empirical analysis, I set up a monetary search model in which bonds provide liquidity services in addition to money. The theory predicts that money supply and the nominal interest rate are positively correlated with the liquidity premium, but the latter is negatively correlated with the bond supply. The empirical analysis over the period from 1946 and 2008 confirms the theoretical findings. This indicates that liquid bonds are substantive substitutes for money and the opportunity cost of holding money plays a key role in asset price determination. The model can rationalize the existence of negative nominal yields, when the nominal interest rate is low and liquid bond supply decreases. |
| Keywords: | asset price, money search model, liquidity, liquidity premium, money supply |
| JEL: | E31 E41 E51 E52 G12 |
| Date: | 2016–08 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:73707&r=upt |
| By: | Olsen, Nina Veflen; Storstad, Oddveig; Samuelsen, Bendik; Langsrud, Solveig; Hagtvedt, Therese; Gregersen, Fredrik; Ueland, Øydis |
| Abstract: | Fall 2014, a researcher from the Norwegian Institute of Public Health stated in a newspaper interview that she never touched chicken with her bare hands. This interview was the beginning of a media storm, which resulted in a 25% sales drop for chicken within three months. To be able to understand why this interview had such a strong effect, we conducted an explorative case study. Findings from previous studies of food safety behavior indicate that consumers are irrational and that information is not enough to change behavior. Gigerenzer (2015), however, argue in a recent article that the claim that people are hardly educable lacks evidence. He cites Simon (1985) quote that “people are generally quite rational; that is, they usually have reasons for what they do” and claims that teaching people to become risk savvy is a true alternative to nudging. The aim of our study is to shed light on the rationality debate by exploring consumers’ reflections and reactions to the previously mentioned food scare article. Data from five focus-group interviews with Norwegian consumers of chicken were transcribed, content analyzed, and in-vitro coded, before we conducted a multiple correspondence analysis in PAST. We developed a graphical plot of our results, which we visually inspected and interpreted. The findings indicate that consumers do reflect when confronted with food scares. Some question the research behind the news, others wonder how dangerous this food scare is compared to other risks. Consumers are not irrational, even though their emotions co-occur more often with their behavior than their reflections. |
| Keywords: | Agribusiness, Food Consumption/Nutrition/Food Safety, Food Security and Poverty, Risk and Uncertainty, |
| Date: | 2016–05 |
| URL: | http://d.repec.org/n?u=RePEc:ags:iefi16:244480&r=upt |
| By: | David Laidler (University of Western Ontario) |
| Abstract: | The problems posed by monetary policy cannot be dealt with by legislating enduring policy rules. With the passage of time, economic understanding does not systematically converge ever more closely on a “true” model of the economy, a process which is now sufficiently far along that our current ideas can form the basis for designing such measures. Rather, economic ideas evolve unsteadily and unpredictably and disagreement about them is routine. They influence the behaviour of the economy and they are influenced by it as they develop, requiring policy principles to adapt as well. Monetary policy thus poses problems that cannot be solved once and for all, but must be coped with continuously. |
| Keywords: | Monetary Policy; Rules versus Discretion; Gold Standard; Revolutions in Macroeconomics |
| JEL: | E5 B1 B2 |
| Date: | 2016 |
| URL: | http://d.repec.org/n?u=RePEc:uwo:uwowop:20164&r=upt |