nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2016‒10‒16
fifteen papers chosen by

  1. Taming models of prospect theory in the Wild? Estimation of Vlcek and Hens (2011) By Jakusch, Sven Thorsten; Meyer, Steffen; Hackethal, Andreas
  2. Theories of Risk: Testing Investor Behaviour on the Taiwan Stock and Stock Index Futures Markets By Clark, Ephraim; Qiao, Zhuo; Wong, Wing-Keung
  3. Dual Process Utility Theory: A Model of Decisions Under Risk and Over Time By Mark Schneider
  4. Decisions under uncertainty in social contexts By Müller, Stephan; Rau, Holger A.
  5. On the applicability of maximum likelihood methods: From experimental to financial data By Jakusch, Sven Thorsten
  6. Do you mind me paying less? Measuring Other-Regarding Preferences in the Market for Taxis By Brit Grosskopf; Graeme Pearce
  7. Taring all investors with the same brush? Evidence for heterogeneity in individual preferences from a maximum likelihood approach By Hackethal, Andreas; Jakusch, Sven Thorsten; Meyer, Steffen
  8. Regular economies with ambiguity aversion By Noé Biheng; Jean-Marc Bonnisseau
  9. Endowment Effects in the Field: Evidence from India's IPO Lotteries By Santosh Anagol; Tarun Ramadorai; Vimal Balasubramaniam
  10. Identification of self-selection biases in field experiments using stated preference experiments By Erik Verhoef; Jasper Knockaert; Stefanie Peer
  11. It is Not Just Confusion! Strategic Uncertainty in an Experimental Asset Market By Eizo Akiyama; Nobuyuki Hanaki; Ryuichiro Ishikawa
  12. Stochastic representatitve agent By Jose Apesteguia; Miguel A. Ballester
  13. Arbitrage Opportunities, Efficiency, and the Role of Risk Preferences in the Hong Kong Property Market By Tsang, Chun-Kei; Wong, Wing-Keung; Horowitz, Ira
  14. Multi-dimensional Living Standards: A Welfare Measure Based on Preferences By Romina Boarini; Fabrice Murtin; Paul Schreyer; Marc Fleurbaey
  15. Attention Variation and Welfare: Theory and Evidence from a Tax Salience Experiment By Alex Rees-Jones; Dmitry Taubinsky

  1. By: Jakusch, Sven Thorsten; Meyer, Steffen; Hackethal, Andreas
    Abstract: Shortcomings revealed by experimental and theoretical researchers such as Allais (1953), Rabin (2000) and Rabin and Thaler (2001) that put the classical expected utility paradigm von Neumann and Morgenstern (1947) into question, led to the proposition of alternative and generalized utility functions, that intend to improve descriptive accuracy. The perhaps best known among those alternative preference theories, that has attracted much popularity among economists, is the so called Prospect Theory by Kahneman and Tversky (1979) and Tversky and Kahneman (1992). Its distinctive features, governed by its set of risk parameters such as risk sensitivity, loss aversion and decision weights, stimulated a series of economic and financial models that build on the previously estimated parameter values by Tversky and Kahneman (1992) to analyze and explain various empirical phenomena for which expected utility doesn't seem to offer a satisfying rationale. In this paper, after providing a brief overview of the relevant literature, we take a closer look at one of those papers, the trading model of Vlcek and Hens (2011) and analyze its implications on Prospect Theory parameters using an adopted maximum likelihood approach for a dataset of 656 individual investors from a large German discount brokerage firm. We find evidence that investors in our dataset are moderately averse to large losses and display high risk sensitivity, supporting the main assumptions of Prospect Theory.
    Keywords: Prospect Theory,Parameter Elicitation,Investors Heterogeneity
    JEL: C35 C51 C52 G02 G11
    Date: 2016
  2. By: Clark, Ephraim; Qiao, Zhuo; Wong, Wing-Keung
    Abstract: Investor behavior towards risk lies at the heart of economic decision making in general and modern investment theory and practice in particular. This paper uses both the mean-variance (MV) criterion and stochastic dominance (SD) procedures to analyze the preferences for four of the most widely studied investor types in the Taiwan stock and stock index futures market. We find that risk averters (concave utility function) prefer spot to futures, whereas risk seekers (convex utility function) prefer futures to spot. Our findings also show that investors with S-shaped utility functions prefer spot (futures) to futures (spot) when markets move upward (downward). Finally, our results imply that investors with reverse S-shaped utility functions prefer futures (spot) to spot (futures) when markets move upward (downward). These results are robust with respect to sub-periods, spot returns including dividends and diversification. Although we do not check whether risk averters, risk seekers, and investors with S-shaped and reverse S-shaped utility functions actually exist in the market, we do show that their existence is plausible. The implications of our findings on market efficiency and the existence of arbitrage opportunities are also discussed in this study.
    Keywords: stochastic dominance; risk aversion; risk seeking; prospect theory; behavioral economics; stock index futures
    JEL: C14 C15 G12
    Date: 2016–04–18
  3. By: Mark Schneider (Economic Science Institute, Chapman University)
    Abstract: The Discounted Expected Utility model has been a major workhorse for analyzing individual behavior for over half a century. However, it cannot account for evidence that risk interacts with time preference, that time interacts with risk preference, that many people are averse to timing risk and do not discount the future exponentially, that discounting depends on the magnitude of outcomes, that risk preferences are not time preferences, and that risk and time preferences are correlated with cognitive ability. Here we address these issues in a decision model based on the interaction of an affective and a reflective valuation process. The resulting Dual Process Utility theory provides a unified approach to modeling risk preference, time preference, and interactions between risk and time preferences. It also provides a unification of models based on a rational economic agent, models based on prospect theory or rankdependent utility, and dual system models of decision making.
    Keywords: Risk preference, Time preference, Cognitive Ability, System 1, System 2
    JEL: D01 D03 D81 D90
    Date: 2016
  4. By: Müller, Stephan; Rau, Holger A.
    Abstract: This paper theoretically and experimentally studies decision-making in risky and social environments. We explore the interdependence of individual risk attitudes and social preferences in form of inequality aversion as two decisive behavioral determinants in such contexts. Our model and the data demonstrate that individual risk aversion is attenuated when lagging behind peers, whereas it is amplified under favorable income inequality. People's choices are not only context-dependent, but are sensitive to their degree of inequality aversion. The findings contribute to the understanding of decision-making in environments like trading at stock markets, the saving patterns of households or charitable giving under uncertainty.
    Keywords: Choice under Uncertainty,Social Comparison,Inequality Aversion,Risk Preferences
    JEL: C91 D03 D63 D81
    Date: 2016
  5. By: Jakusch, Sven Thorsten
    Abstract: This paper addresses whether and to what extent econometric methods used in experimental studies can be adapted and applied to financial data to detect the best-fitting preference model. To address the research question, we implement a frequently used nonlinear probit model in the style of Hey and Orme (1994) and base our analysis on a simulation stud. In detail, we simulate trading sequences for a set of utility models and try to identify the underlying utility model and its parameterization used to generate these sequences by maximum likelihood. We find that for a very broad classification of utility models, this method provides acceptable outcomes. Yet, a closer look at the preference parameters reveals several caveats that come along with typical issues attached to financial data, and that some of these issues seems to drive our results. In particular, deviations are attributable to effects stemming from multicollinearity and coherent under-identification problems, where some of these detrimental effects can be captured up to a certain degree by adjusting the error term specification. Furthermore, additional uncertainty stemming from changing market parameter estimates affects the precision of our estimates for risk preferences and cannot be simply remedied by using a higher standard deviation of the error term or a different assumption regarding its stochastic process. Particularly, if the variance of the error term becomes large, we detect a tendency to identify SPT as utility model providing the best fit to simulated trading sequences. We also find that a frequent issue, namely serial correlation of the residuals, does not seem to be significant. However, we detected a tendency to prefer nesting models over nested utility models, which is particularly prevalent if RDU and EXPO utility models are estimated along with EUT and CRRA utility models.
    Keywords: Utility Functions,Model Selection,Parameter Elicitation
    JEL: C15 C35 C49 C51 C52
    Date: 2016
  6. By: Brit Grosskopf; Graeme Pearce
    Abstract: We present a natural field experiment designed to measure other{regarding preferences in the market for taxis. We employed testers of varying ethnicity to take a number of predetermined taxi journeys. In each case we endowed them with only 80% of the expected fare. Testers revealed the amount they could afford to pay to the driver mid-journey and asked for a portion of the journey for free. In a 2x2 between{subjects design we vary the length of the journey and whether drivers havereputational concerns or not. We find that the majority of drivers give at least part of the journey for free and over 25% complete the journey. Giving is found to be proportional to the length of the journey, and the drivers' reputational concerns do not explain their behaviour. Evidence of strong out{group negativity against black testers by both white and South Asian drivers is also reported. In order to link our empirical analysis to behavioural theory we estimate the parameters of a number of utility functions. The data and the structural analysis lend support to the quantitative predictions of experiments that measure other{regarding preferences, and shed further light on how discrimination can manifest itself within our preferences.
    Date: 2016
  7. By: Hackethal, Andreas; Jakusch, Sven Thorsten; Meyer, Steffen
    Abstract: Microeconomic modeling of investors behavior in financial markets and its results crucially depends on assumptions about the mathematical shape of the underlying preference functions as well as their parameterizations. With the purpose to shed some light on the question, which preferences towards risky financial outcomes prevail in stock markets, we adopted and applied a maximum likelihood approach from the field of experimental economics on a randomly selected dataset of 656 private investors of a large German discount brokerage firm. According to our analysis we find evidence that the majority of these clients follow trading pattern in accordance with Prospect Theory (Kahneman and Tversky (1979)). We also find that observable sociodemographic and personal characteristics such as gender or age don't seem to correlate with specific preference types. With respect to the overall impact of preferences on trading behavior, we find a moderate impact of preferences on trading decisions of individual investors. A classification of investors according to various utility types reveals that the strength of the impact of preferences on an investors' rading behavior is not connected to most personal characteristics, but seems to be related to round-trip length.
    Keywords: Utility Theory,Maximum Likelihood,Individual Investors
    JEL: C35 C51 C52 G02 G11
    Date: 2016
  8. By: Noé Biheng (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, PSE - Paris School of Economics); Jean-Marc Bonnisseau (PSE - Paris School of Economics, CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique)
    Abstract: We consider a family of exchange economies with complete markets where consumers have multiprior preferences representing their ambiguity aversion. Under a linear independence assumption, we prove that regular economies are generic. Regular economies exhibit enjoyable properties: odd finite number of equilibrium prices, local constancy of this number, local differentiable selections of the equilibrium prices. Thus, even if ambiguity aversion is represented by non-differentiable multiprior preferences, economies retain generically the properties of the differentiable approach.
    Keywords: demand function,general equilibrium,ambiguity aver-sion,multiprior preferences,regular economies,Lipschitz behavior
    Date: 2015
  9. By: Santosh Anagol; Tarun Ramadorai; Vimal Balasubramaniam
    Abstract: Winners of randomly assigned initial public offering (IPO) lottery shares are significantly more likely to hold these shares than lottery losers 1, 6, and even 24 months after the random allocation. This effect persists in samples of wealthy and highly active investors, suggesting along with additional evidence that this type of "endowment effect" is not solely driven by portfolio inertia or wealth effects. The effect decreases as experience in the IPO market increases, but persists even for the most experienced investors. These results suggest that agents' preferences and/or beliefs about an asset are not independent of ownership, providing field evidence derived from the behavior of 1.5 million Indian stock investors which is in line with the large laboratory literature documenting endowment effects. We evaluate the extent to which prominent models of endowment effects and/or investor behavior can explain our results. A combination of inattention and non-standard preferences (realization utility) or non-standard beliefs (salience based probability distortions) appears most consistent with our findings.
    Date: 2016
  10. By: Erik Verhoef; Jasper Knockaert; Stefanie Peer
    Abstract: If left unidentified and uncorrected, self-selection biases may greatly compromise the external validity of the outcomes of field experiments. We show that self-selection biases in terms of observed und unobserved characteristics can be well identified and corrected by means of a complementary stated preference (SP) experiment conducted among the participants and non-participants of a field experiment. In the SP experiment, respondents are confronted with hypothetical choice situations that closely resemble the choice situations present in the field experiment. The SP experiment does not only allow us to compare participants and non-participants with respect to their behavior and implied preferences in the hypothetical choice situations, but also renders it possible to infer how non-participants would have behaved if they had decided to participate, using an innovative modeling approach to elicit the corresponding preference structures. We apply this approach in the context of a large-scale field experiment in which train commuters received monetary rewards for traveling outside peak hours. We find strong self-selection biases, especially with respect to the marginal utility of income, which is significantly higher among participants of the field experiment.
    Date: 2016
  11. By: Eizo Akiyama (Faculty of Engineering, Information and Systems, University of Tsukuba - University of Tsukuba); Nobuyuki Hanaki (GREDEG - Groupe de Recherche en Droit, Economie et Gestion - UNS - Université Nice Sophia Antipolis - CNRS - Centre National de la Recherche Scientifique); Ryuichiro Ishikawa (Faculty of Engineering, Information and Systems, University of Tsukuba - University of Tsukuba)
    Abstract: To what extent is the observed mispricing in experimental asset markets caused by strategic uncertainty and by confusion? We address this question by comparing subjects' initial price forecasts in two market environments: one with six human traders, and the other with one human and five computer traders. We find that both strategic uncertainty and confusion contribute equally to the median initial forecast deviation from the fundamental value. The effect of strategic uncertainty is greater for subjects with a perfect score in the Cognitive Reflection Test, and it is not significant for those with low scores.
    Keywords: Asset markets, Computer traders, Cognitive Reflection Test,Bounded rationality, Strategic uncertainty, Experiment
    Date: 2016–09–07
  12. By: Jose Apesteguia; Miguel A. Ballester
    Abstract: Consider the aggregation of a collection of individual stochastic behaviors that fit a given stochastic choice model. We say that such a model has a representative agent if their aggregate stochastic behaviour also fits the model. We show that the Luce model and several prominent extensions thereof do not have a representative agent. On the positive side, we show that the random utility model and several domain-specific restrictions thereof do have a representative agent.
    Keywords: Representative agent; Stochastic choice.
    JEL: D0 D7 E1
    Date: 2016–09
  13. By: Tsang, Chun-Kei; Wong, Wing-Keung; Horowitz, Ira
    Abstract: This paper aims at investigating how a prospective buyer’s optimal home-size purchase can be determined by means of a stochastic-dominance (SD) analysis of historical data of Hong Kong. By means of SD analysis, the paper employs monthly property yields in Hong Kong over a 15-year period to illustrate how buyers of different risk preference may optimize their home-size purchase. Regardless of whether the buyer eschews risk, embraces risk, or indifference to it, in any adjacent pairing of five well-defined housing classes, the smaller class provides the optimal purchase. In addition, risk averters focusing on total yield would prefer to invest in the smallest and second- smallest classes than in the largest class. As the smaller class provides the optimal purchase, the smallest class affords the buyer the optimal purchase over all classes in this important housing market – at least where rental yields are of primary concern. The findings suggest that in the Hong Kong housing market, long-term investors may be better off purchasing smaller homes. For other type of investors, it depends on their risk preference. There is a very small body of empirical literature on housing investment, especially if focuses on the optimal home-size purchase.
    Keywords: urban studies; stochastic dominance; risk averters, risk seekers, investors with S-shaped and reverse S-shaped utilities, housing investment
    JEL: C14 G14 R31
    Date: 2016–05–17
  14. By: Romina Boarini; Fabrice Murtin; Paul Schreyer; Marc Fleurbaey
    Abstract: We compute a distribution-adjusted welfare measure that aggregates outcomes in three dimensions of well-being, namely income, employment and longevity. Aggregation weights reflect preferences of people on these dimensions. The welfare measure is calculated for 26 OECD countries and selected emerging economies, and covers about three decades. Relying on a single theoretical model of a hypothetical representative agent, we combine life satisfaction regressions to capture the full welfare losses of unemployment with a calibration approach to capture the value of longevity. We test for robustness of results over a series of datasets and specifications and find that the resulting estimated shadow prices of (one percentage point of) unemployment and one year of longevity average 2% and 6% of income respectively. While we assume an identical utility function for all individuals, shadow prices of unemployment and longevity vary both across countries and within countries across income groups. We find that economic growth differs significantly from the growth of our welfare measure. The latter grew faster than GDP thanks to the gains that countries experienced on longevity, but was also more volatile due to changes in unemployment. Rising income inequality exerts a negative effect on our welfare measure. Gains in longevity have almost the same impact on welfare as income growth, while the long-term impact of employment was smaller. Nous calculons une mesure de niveau de vie ajustée pour le degré d’inégalité et agrégeant le revenu, l’emploi et l’espérance de vie. Les poids associés à ces dimensions reflètent les préférences des populations. Cette mesure de niveau de vie qui couvre trois décennies est calculée pour 26 pays de l’OCDE et une sélection de pays émergeants. En nous basant sur un modèle théorique unique d’un agent représentatif hypothétique, nous combinons des régressions de satisfaction envers la vie pour capter le coût social du chômage avec une approche de calibration pour rendre compte de la valeur monétaire de la longévité. Nous testons la robustesse des résultats à l’aide d’un ensemble de bases de données et de spécifications différentes, et nous trouvons que les prix fictifs estimés d’un point de pourcentage de chômage et d’une année d’espérance de vie sont en moyenne respectivement égaux à 2% et 6% du revenu des ménages. Alors qu’une fonction d’utilité unique est utilisée pour tous les individus, les prix fictifs du chômage et de l’espérance de vie varient à la fois entre pays et entre groupes de revenu à l’intérieur des pays. Nous montrons que la croissance économique diffère significativement de la croissance de notre mesure de niveau de vie. Celle-ci a crû plus vite que le PIB en vertu des gains d’espérance de vie, mais a été également plus volatile à cause des variations du taux de chômage. L’augmentation des inégalités de revenu a exercé un effet négatif sur notre mesure de niveau de vie. Les gains d’espérance de vie ont eu pratiquement le même impact sur le niveau de vie que la croissance économique, alors que l’impact de long-terme de l’emploi a été plus faible.
    Keywords: living standards, welfare, well-being, measurement
    JEL: I18 I31 I32 I38 J17 J18
    Date: 2016–10–11
  15. By: Alex Rees-Jones; Dmitry Taubinsky
    Abstract: This paper shows that accounting for variation in mistakes can be crucial for welfare analysis. Focusing on consumer underreaction to not-fully-salient sales taxes, we show theoretically that the efficiency costs of taxation are amplified by 1) individual differences in under reaction and 2) the degree to which attention is increasing with the size of the tax rate. To empirically assess the importance of these issues, we implement an online shopping experiment in which 2,998 consumers-matching the U.S. adult population on key demographics-purchase common household products, facing tax rates that vary in size and salience. We find that: 1) there are significant individual differences in underreaction to taxes. Accounting for this heterogeneity increases the efficiency cost of taxation estimates by at least 200%, as compared to estimates generated from a representative agent model. 2) Tripling existing sales tax rates roughly doubles consumers' attention to taxes. Our results provide new insights into the mechanisms and determinants of boundedly rational processing of not-fully-salient incentives, and our general approach provides a framework for robust behavioral welfare analysis.
    Date: 2016

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