nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2016‒10‒23
sixteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Dynamic consistency of expected utility under non-classical(quantum) uncertainty By Vladimir Ivanovitch Danilov; Ariane Lambert-Mogiliansky; Vassili Vergopoulos
  2. Conditional Expected Utility Criteria for Decision Making under Ignorance or Objective Ambiguity By Nicolas Gravel; Thierry Marchant; Arunava Sen
  3. An explicit formula for optimal portfolios in complete Wiener driven markets: a functional It\^o calculus approach By Kristoffer Lindensj\"o
  4. Consistent tests for risk seeking behavior: A stochastic dominance approach By Stelios Arvanitis; Nikolas Topaloglou
  5. Mentalism Versus Behaviourism in Economics: A Philosophy-of-Science Perspective By Franz Dietrich; Christian List
  6. Non stationary additive utility and time consistency By Nicolas Drouhin
  7. Goal Setting in the Principal-Agent Model: Weak Incentives for Strong Performance By Brice Corgnet; Joaquín Gómez-Miñambres; Roberto Hernán-Gonzalez
  8. Stochastic Dominance and Investors’ Behavior towards Risk: The Hong Kong Stocks and Futures Markets By Lam, Kin; Lean, Hooi Hooi; Wong, Wing-Keung
  9. Wealth, Portfolio Allocations, and Risk Preference By Robert Östling; Erik Lindqvist; David Cesarini; Joseph Briggs
  10. A revealed preference theory of monotone choice and strategic complementarity By Natalia Lazzati; John K.-H. Quah; Koji Shirai
  11. Optimal Consumption and Investment with Fixed and Proportional Transaction Costs By Albert Altarovici; Max Reppen; H. Mete Soner
  12. Optimal Deterrence of Cooperation By Stéphane Gonzalez; Aymeric Lardon
  13. Representation of Binary Choice Probabilities. Part I: Scalability By Matthew Ryan
  14. Seeking risk or answering smart? Framing in elementary schools By Wagner, Valentin
  15. Measuring Uncertainty and Its Impact on the Economy By Clark, Todd E.; Carriero, Andrea; Massimiliano, Marcellino
  16. A generalized model of sales By Sandro Shelegia; Chris M. Wilson

  1. By: Vladimir Ivanovitch Danilov (CEMI - Central Economic Mathematical Institute - Russian Academy of Sciences); Ariane Lambert-Mogiliansky (PSE - Paris School of Economics, PSE - Paris-Jourdan Sciences Economiques - CNRS - Centre National de la Recherche Scientifique - INRA - Institut National de la Recherche Agronomique - EHESS - École des hautes études en sciences sociales - ENS Paris - École normale supérieure - Paris - École des Ponts ParisTech (ENPC)); Vassili Vergopoulos (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, PSE - Paris School of Economics)
    Abstract: Quantum cognition is a recent and rapidely growing field. In this paper we developan expected utility theory in a context of non-classical (quantum) uncertainty. We replace the classical state space with a Hilbert space which allows introducing the concept of quantum lottery. Within that framework we formulate sufficient and necessary axioms on preferences over quantum lotteries to establish a representation theorem. We show that demanding the consistency of choice behavior conditional on new information is equivalent to the von Neuman-Luders postulate applied to beliefs. In our context, dynamic consistency is shown not to secure Savage's Sure Thing Principle (in its dynamic version). Finally, we discuss the interpretation and value of our results for rationality and behavioral economics.
    Keywords: Quantum cognition
    Date: 2016–05–31
  2. By: Nicolas Gravel (AMSE - Aix-Marseille School of Economics - EHESS - École des hautes études en sciences sociales - Centre national de la recherche scientifique (CNRS) - Ecole Centrale Marseille (ECM) - AMU - Aix-Marseille Université); Thierry Marchant (Department of Data Analysis - Ghent University [Belgium]); Arunava Sen (Indian Statistical Institute [New Delhi])
    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
    Date: 2016–04
  3. By: Kristoffer Lindensj\"o
    Abstract: The optimal investment problem is one of the most important problems in mathematical finance. The main contribution of the present paper is an explicit formula for the optimal portfolio process. Our optimal investment problem is that of maximizing the expected value of a standard general utility function of terminal wealth in a standard complete Wiener driven financial market. In order to derive the formula for the optimal portfolio we use the recently developed functional It\^o calculus and more specifically an explicit martingale representation theorem. A main component in the formula for the optimal portfolio is a vertical derivative with respect to the driving Wiener process. The vertical derivative is an important component of functional It\^o calculus.
    Date: 2016–10
  4. By: Stelios Arvanitis (Athens University of Economics and Business); Nikolas Topaloglou (Athens University of Economics and Business)
    Abstract: We develop non-parametric tests for prospect stochastic dominance Efficiency (PSDE) and Markowitz stochastic dominance efficiency (MSDE) with rejection regions determined by block bootstrap resampling techniques. Under the appropriate conditions we show that they are asymptotically conservative and consistent. We engage into Monte Carlo experiments to assess the nite sample size and power of the tests allowing for the presence of numerical errors. We use them to empirically analyze investor preferences and beliefs by testing whether the value-weighted market portfolio can be considered as efficient according to prospect and Markowitz stochastic dominance criteria when confronted to diversi cation principles made of risky assets. Our results indicate that we cannot reject the hypothesis of prospect stochastic dominance efficiency for the market portfolio. This is supportive of the claim that the particular portfolio can be rationalized as the optimal choice for any S-shaped utility function. Instead, we reject the hypothesis for Markowitz stochastic dominance, which could imply that there exist reverse S-shaped utility functions that do not rationalize the market portfolio.
    Keywords: Non parametric test, prospect stochastic dominance efficiency,Markowitz stochastic dominance efficiency, simplical complex, extremal point, Linear Programming, Mixed Integer Programming, Block Bootstrap, Consistency
    JEL: C12 C13 C15 C44 D81 G11
    Date: 2015–11
  5. By: Franz Dietrich (PSE - Paris School of Economics, CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Christian List (LSE - London School of Economics and Political Science)
    Abstract: Behaviourism is the view that preferences, beliefs, and other mental states in social-scientific theories are nothing but constructs re-describing people's behaviour. Mentalism is the view that they capture real phenomena, on a par with the unobservables in science, such as electrons and electromagnetic fields. While behaviourism has gone out of fashion in psychology, it remains influential in economics, especially in 'revealed preference' theory. We defend mentalism in economics, construed as a positive science, and show that it fits best scientific practice. We distinguish mentalism from, and reject, the radical neuroeconomic view that behaviour should be explained in terms of brain processes, as distinct from mental states.
    Keywords: decision theory,scientific realism,Mentalism,behaviourism,revealed preference
    Date: 2016–04–21
  6. By: Nicolas Drouhin (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, ENS Cachan - École normale supérieure - Cachan)
    Abstract: By solving dynamic optimization programs, I study the most general class of additive intertemporal utility functionals. They are not necessarily stationary, and do not necessarily multiplicatively separate a discount factor from "per-period utility". I prove that time consistency holds if and only if the period felicity function is multiplicatively separable in t, the date of decision and in s, the date of consumption, or equivalently, if the Fisherian instantaneous subjective discount rate does not depend on t. The model allows to explain"anomalies in intertemporal choice" and various empirical regularities, even when the agents are time consistent. On the other hand, the model allows to characterize the "effective consumption profile" of naive, time-inconsistent agents mathematically.
    Keywords: intertemporal choice, life cycle theory of consumption and saving, stationarity, time consistency, time invariance, exponential discounting, hyperbolic discounting, aging
    Date: 2016–01–19
  7. By: Brice Corgnet (EMLYON Business school - EMLYON Business School, GATE Lyon Saint-Étienne - Groupe d'analyse et de théorie économique - CNRS - Centre National de la Recherche Scientifique - UCBL - Université Claude Bernard Lyon 1 - UL2 - Université Lumière - Lyon 2 - Université Jean Monnet - Saint-Etienne - PRES Université de Lyon - ENS Lyon - École normale supérieure - Lyon); Joaquín Gómez-Miñambres (Chapman University - Chapman University, Bucknell University); Roberto Hernán-Gonzalez (Nottingham University Business School - UON - University of 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
    Date: 2016
  8. By: Lam, Kin; Lean, Hooi Hooi; Wong, Wing-Keung
    Abstract: This paper applies stochastic dominance (SD) tests to examine the dominance relationships between the futures and spot markets in Hong Kong. We also analyze the preferences for the risk averters, risk seekers, prospect investors, and Markowitz investors with further in dept of their positive and negative domains in these markets. We find that for the risk averters, spot dominates futures while for the risk seekers, futures dominate spot. This implies that the risk averters prefer to buy indexed stocks, while risk seekers are attracted to long index futures to maximize their expected utilities, but not necessary their wealth. We also conclude that in general, the prospect investors prefer spot in the positive domain and prefer futures in the negative domain while the Markowitz investors prefer spot in the negative domain and prefer futures in the positive domain.
    Keywords: stochastic dominance; stock index futures; risk preference; S-shape utility functions.
    JEL: C14 C15 G12
    Date: 2016–10–09
  9. By: Robert Östling (Stockholm University); Erik Lindqvist (Stockholm School of Economics); David Cesarini (New York University); Joseph Briggs (New York University)
    Abstract: Using an administrative data set of Swedish lottery players that were randomly assigned 500M USD, we estimate the causal effect of wealth on the share of risky assets in a household's financial portfolio. We find that $150,000 causes a 9 percentage point decrease in the average household portfolio's equity share in their financial portfolio. The effect is immediate, not explained by passive investing, and negative in all subsamples considered. A decrease in risk taking could indicate increasing relative risk aversion. However, we show that a quantitative life-cycle model with realistic income profile can replicate the estimated decrease in portfolio risk, and that caution should be used when inferring risk preference from portfolio shares.
    Date: 2016
  10. By: Natalia Lazzati (Department of Economics, University of California Santa Cruz); John K.-H. Quah (Department of Economics, Johns Hopkins University); Koji Shirai (School of Economics, Kwansei Gakuin University)
    Abstract: We develop revealed preference characterizations of (1) monotone choice in the context of individual decision making and (2) strategic complementarity in the context of simultaneous games. We first consider the case where the observer has access to panel data and then extend the analysis to the case where data sets are cross sectional and preferences heterogenous. Lastly, we apply our techniques to investigate the possibility of spousal inuence in smoking decisions.
    Keywords: monotone comparative statics, single crossing differences, interval dominance, supermodular games, lattices
    JEL: C6 C7 D7
    Date: 2016–10
  11. By: Albert Altarovici; Max Reppen; H. Mete Soner
    Abstract: The classical optimal investment and consumption problem with infinite horizon is studied in the presence of transaction costs. Both proportional and fixed costs as well as general utility functions are considered. Weak dynamic programming is proved in the general setting and a comparison result for possibly discontinuous viscosity solutions of the dynamic programming equation is provided. Detailed numerical experiments illustrate several properties of the optimal investment strategies.
    Date: 2016–10
  12. By: Stéphane Gonzalez (GATE Lyon Saint-Étienne - Groupe d'analyse et de théorie économique - ENS Lyon - École normale supérieure - Lyon - UL2 - Université Lumière - Lyon 2 - UCBL - Université Claude Bernard Lyon 1 - Université Jean Monnet - Saint-Etienne - PRES Université de Lyon - CNRS - Centre National de la Recherche Scientifique); Aymeric Lardon (GREDEG - Groupe de Recherche en Droit, Economie et Gestion - UNS - Université Nice Sophia Antipolis - CNRS - Centre National de la Recherche Scientifique)
    Abstract: We introduce axiomatically a new solution concept for cooperative games with transferable utility inspired by the core. While core solution concepts have investigated the sustainability of cooperation among players, our solution concept, called contraction core, focuses on the deterrence of cooperation. The main interest of the contraction core is to provide a monetary measure of the robustness of cooperation into the grand coalition. We motivate this concept by providing optimal fine imposed by competition authorities for the dismantling of cartels in oligopolistic markets. We characterize the contraction core on the set of balanced cooperative games with transferable utility by four axioms: the two classic axioms of non-emptiness and individual rationality, a superadditivity principle and a new axiom of consistency.
    Keywords: TU-game, contraction core, optimal fine, Cournot oligopoly, axiomatization
    Date: 2016
  13. By: Matthew Ryan (School of Economics, Auckland University of Technology, NZ)
    Abstract: Scalability refers to the existence of a utility scale on alternatives, with respect to which binary choice probabilities are suitably monotone. This is a fundamental concept in psychophysical theory (Falmagne, 1985). We introduce a new notion of scalability which we call strict scalability, and establish axiomatic foundations for this concept. Strict scalability lies between the classical notion of simple scalability, which was axiomatised by Tversky and Russo (1969), and the weaker notion of monotone scalability, which was axiomatised by Fishburn (1973). When the set of alternatives is countable, a binary choice probability is strictly scalable if and only if it satis?es the familiar condition of weak substitutability.
    Date: 2016–04
  14. By: Wagner, Valentin
    Abstract: This paper investigates how framing manipulations affect the quantity and quality of decisions. In a field experiment in elementary schools, 1.377 pupils are randomly assigned to one of three conditions in a multiple-choice test: (i) gain frame (Control), (ii) loss frame (Loss) and (iii) gain frame with a downward shift of the point scale (Negative). On average, pupils in both treatment groups answer significantly more questions correctly compared to the "traditional grading". This increase is driven by two different mechanisms. While pupils in the Loss Treatment increase significantly the quantity of answered questions - seek more risk - pupils in the Negative Treatment seem to increase the quality of answers - answer more accurately. Moreover, differentiating pupils by their initial ability shows that a downward shift of the point scale is superior to loss framing. High-performers increase performance in both treatment groups but motivation is significantly crowded out for low-performers only in the Loss Treatment.
    Keywords: behavioral decision making,quantity and quality of decisions,framing,loss aversion,field experiment,motivation,education
    JEL: D03 I20 D80 C93 M54
    Date: 2016
  15. By: Clark, Todd E. (Federal Reserve Bank of Cleveland); Carriero, Andrea (Queen Mary, University of London); Massimiliano, Marcellino (Bocconi University, IGIER and CEPR)
    Abstract: We propose a new framework for measuring uncertainty and its effects on the economy, based on a large VAR model with errors whose stochastic volatility is driven by two common unobservable factors, representing aggregate macroeconomic and financial uncertainty. The uncertainty measures can also influence the levels of the variables so that, contrary to most existing measures, ours reflect changes in both the conditional mean and volatility of the variables, and their impact on the economy can be assessed within the same framework. Moreover, identification of the uncertainty shocks is simplified with respect to standard VAR-based analysis, in line with the FAVAR approach and with heteroskedasticity-based identification. Finally, the model, which is also applicable in other contexts, is estimated with a new Bayesian algorithm, which is computationally efficient and allows for jointly modeling many variables, while previous VAR models with stochastic volatility could only handle a handful of variables. Empirically, we apply the method to estimate uncertainty and its effects using US data, finding that there is indeed substantial commonality in uncertainty, sizable effects of uncertainty on key macroeconomic and financial variables with responses in line with economic theory.
    Keywords: Bayesian VARs; stochastic volatility; large datasets;
    JEL: C11 C13 C33 C55 E44
    Date: 2016–10–14
  16. By: Sandro Shelegia; Chris M. Wilson
    Abstract: To provide a more exible workhorse model of temporary price reductions or "sales", this paper presents a substantially generalized "clearinghouse" sales framework. Our framework permits multiple dimensions of firm heterogeneity, and views firms as competing directly in utility rather than prices. The paper i) reproduces and extends many equilibria from the existing literature, ii) offers a range of new results on how firm heterogeneity affects market outcomes, iii) provides original insights into the number and type of firms that use sales, and iv) extends a "cleaning" procedure that is commonly used in empirical studies of sales and price dispersion.
    Keywords: Sales; Price Dispersion; Advertising; Clearinghouse; Heterogeneity.
    JEL: L13 D43 M3
    Date: 2016–10

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