nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2017‒02‒26
nineteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Ambiguous Correlation By Epstein, Larry G.; Halevy, Yoram
  2. Dynamic Valuation of Weather Derivatives under Default Risk By CMaria Osipenko; Wolfgang Karl Härdle; ;
  3. Investment decisions and negative interest rates By Bracha, Anat
  4. Linking risk aversion, time preference and fertilizer use in Burkina Faso By Le Cotty, T.; Maître d’Hôtel, E.; Soubeyran, R.; Subervie, J.
  5. Dual decision processes: Retrieving preferences when some choices are intuitive By Francesco Cerigioni
  6. Representation and Social Regret in Risk-Taking By İriş, Doruk
  7. Incidental emotions and risk-taking: An experimental analysis By Colasante, Annarita; Marini, Matteo M.; Russo, Alberto
  8. The External Validity of Consequential Stated Preference Studies: a comment By David A. Comerford; Nick Hanley
  9. Outcome Uncertainty, Fan Travel, and Aggregate Attendance By Brad R. Humphreys; Thomas J. Miceli
  10. On the gains of using high frequency data and higher moments in Portfolio Selection By Rui Pedro Brito; Hélder Sebastião; Pedro Godinho
  11. Lower Tax For Minimum Wage Earners By Jim Jin; Felix FitzRoy
  12. A Risk Economic Approach to Nuclear Power Generation:From Daniel Bernoulli to Keynes and Knight By Yasuhiro Sakai
  13. Model Uncertainty and the Direction of Fit of the Postwar U.S. Phillips Curve(s) By Francesca Rondina
  14. Valoración económica de los bienes y servicios ecosistémicos del golfo de Tribugá - Colombia By Luis Carlos Pupo Garcia; Jairo Parada Corrales
  15. The 2017 Power Trading Agent Competition By Ketter, W.; Collins, J.; de Weerdt, M.M.
  16. Measuring Normative Risk Preferences By Alserda, G.A.G.
  17. Behavioral Characterizations of Naiveté for Time-Inconsistent Preferences By David S. Ahn; Ryota Iijima; Yves Le Yaouanq; Todd Sarver
  18. Communication Games with Optional Verification By Simon Schopohl
  19. The relationship between perceived difficulty and randomness in discrete choice experiments: Investigating reasons for and consequences of difficulty By Tobias Börger; Oliver Frör; Sören Weiß

  1. By: Epstein, Larry G.; Halevy, Yoram
    Abstract: Many decisions are made in environments where outcomes are determined by the realization of multiple random events. A decision maker may be uncertain how these events are related. We identify and experimentally substantiate behavior that intuitively reflects a lack of confidence in their joint distribution. Our findings suggest a dimension of ambiguity which is different from that in the classical distinction between risk and "Knightian uncertainty."
    Keywords: ambiguity, uncertainty, correlation, Ellsberg
    Date: 2017–02–15
  2. By: CMaria Osipenko; Wolfgang Karl Härdle; ;
    Abstract: Weather derivatives are contingent claims with payo based on a pre-speci ed weather index. Firms exposed to weather risk can transfer it to nancial markets via weather derivatives. We develop a utility-based model for pricing baskets of weather derivatives in over-the-counter markets under counterparty default risk. In our model, agents maximise the expected utility of their terminal wealth, while they dynamically rebalance their weather portfolios over a nite investment horizon. Via partial market clearing, we obtain semi-closed forms for the equilibrium prices of weather derivatives and for the optimal strategies of the agents. We give an example on how to price rainfall derivatives on selected stations in China in the universe of a nancial investor and a weather exposed crop insurer.
    Keywords: derivative securities, asset pricing models
    Date: 2017–02
  3. By: Bracha, Anat (Federal Reserve Bank of Boston)
    Abstract: While the current European Central Bank deposit rate and 2-year German government bond yields are negative, the U.S. 2-year government bond and deposit rates are positive. Insights from Prospect Theory suggest that this situation may lead to an excess flow of funds into the United States. Yet the environment of negative interest rates is different from the environment considered in Prospect Theory and subsequent literature, since decisions are framed in terms of rates of return rather than absolute amounts and the task involves the allocation of funds rather than a choice or a pricing task as is often used in the literature. Moreover, parking money in the United States as a foreign investor may lead to a mixed lottery due to exchange rate risk, while the literature mostly studies non-mixed lotteries. We therefore explore investors’ behavior in a mixed-return lottery, using a series of lab experiments where the task is to allocate money between two portfolios with either a sure return or a risky return. We use a between-subject design such that, while the investment decisions are the same, those in the negative frame allocate funds between a sure negative return and a lottery, and those in the positive frame allocate funds between a sure positive return and a lottery. Surprisingly, we find no framing effect on investment, a result that holds for a large range of stakes, no matter whether the money to invest is literally on the table, regardless of the language used to describe the problem (abstract or not), and no matter whether the lottery is a two-state or a three-state lottery. We find that this result is not driven by whether the task is continuous rather than discrete or because the risky portfolio is a mixed lottery. Not only do we find no effect of the frame on the investment decision, we also find no evidence of risk-seeking in the loss domain, and that the behavior is mostly risk-neutral.
    Keywords: investment decision; framing effect; Prospect Theory; lab experiment
    JEL: D03 D81 G11
    Date: 2016–11–01
  4. By: Le Cotty, T.; Maître d’Hôtel, E.; Soubeyran, R.; Subervie, J.
    Abstract: This paper investigates whether Burkinabe maize farmers’ fertilizer-use decisions are correlated with their risk and time preferences. We conducted a survey and a series of hypothetical experiments on a sample of 1,500 farmers. We ?nd that more patient farmers do use more fertilizer, but it is only because they plant more maize (a fertilizer-intensive crop) rather than because they use more fertilizer per hectare of maize planted. Conversely, we ?nd no statistically signi?cant link between risk aversion and fertilizer use. We use a simple two-period model, which suggests that risk aversion may indeed have an ambiguous effect on fertilizer use. ....French Abstract: Ce papier analyse la relation entre les décisions d'utilisation d'engrais des producteurs de maïs au Burkina Faso et les caractéristiques de ces producteurs en termes d'impatience et d'aversion au risque. 1500 producteurs ont été enquêtés sur leurs activités agricoles et ont participé à un dispositif expérimental basé sur des paiements hypothétiques. Notre principal résultat est sur la relation entre l'impatience et l'utilisation d'engrais : nous établissons que les producteurs les plus patients utilisent davantage d'engrais, et plantent davantage de maïs, qui est une plante qui requiert de l'engrais, sans pour autant intensifier leur production de maïs. Nous ne trouvons pas de relation significative entre l'aversion au risque et l'utilisation d'engrais.
    JEL: D13 D14 D91 O12
    Date: 2017
  5. By: Francesco Cerigioni
    Abstract: Evidence from cognitive sciences shows that some choices are conscious and re ect individual prefer- ences while others tend to be intuitive, driven by analogies with past experiences. Under these circum- stances, usual economic modeling might not be valid because not all choices are the consequence of individual tastes. We here propose a behavioral model that can be used in standard economic analysis that formalizes how conscious and intuitive choices arise by presenting a decision maker composed by two systems. One system compares past decision problems with the one the decision maker faces, and it replicates past behavior when the problems are similar enough (Intuitive choices). Otherwise, a second system is activated and preferences are maximized (Conscious choices). We then present a novel method capable of nding conscious choices just from observed behavior and nally, we provide a choice theoretical foundation of the model and discuss its importance as a general framework to study behavioral inertia.
    Keywords: Dual Processes, Fast and Slow Thinking, Similarity, Revealed Preferences, Memory, Intuition
    JEL: D01 D03 D60
    Date: 2016–09
  6. By: İriş, Doruk
    Abstract: Representing others brings responsibility and fear of letting others down (social regret). We incorporate these phenomena in a theoretical model and provide a psychological perspective to explain the individual-group discontinuity in risk-taking activities. A representative makes a state-wise comparison of the consequences of her decision and an unchosen advice given by a group member. Social regret-aversion renders extreme utility differences salient and allows both risky and cautious shifts.
    Keywords: Social representation; Social regret-aversion; Risk-taking; Individual-group discontinuity; Risky shift; Cautious shift.
    JEL: A13 D03 D81
    Date: 2017–02–22
  7. By: Colasante, Annarita; Marini, Matteo M.; Russo, Alberto
    Abstract: In this paper we test in a controlled environment the impact of incidental emotions induced through musical stimuli on individual risk-taking behavior. A modified version of the Multiple Price List method is used to elicit risk preference. We find that both positive and negative stimuli make experimental subjects more risk averse than subjects in the neutral treatment. This result is obtained with respect to the first lottery, while the impact of music on risk-taking is not statistically significant in the subsequent lottery, meaning that its effect vanishes as time elapses.
    Keywords: laboratory experiment, music, mood induction, preference elicitation, risk aversion.
    JEL: C91 D81
    Date: 2017–02–22
  8. By: David A. Comerford (Division of Economics, University of Stirling); Nick Hanley (School of Geography and Sustainable Development, University of St. Andrews)
    Abstract: Mounting evidence suggests that Consequential Discrete Choice Experiments (CDCEs) are internally valid i.e. they elicit a de-facto revealed preference. This comment asks whether CDCEs are always externally valid. For instance, when it comes to existence values, policy makers require a valuation of the benefit that derives from passively experiencing the continued existence of a good, whereas CDCEs measure the value that derives from actively intervening to maintain or increase the supply of a good. We show that CDCEs will recommend suboptimal levels of Pigovian taxes and public goods provision. We suggest potential alternatives to CDCEs that future research should consider.
    Keywords: Cost Benefit Analysis; Stated Preference; Willingness-to-pay; Consequentiality; Act utility; Exogenous Goods; Preferences-over-actions; Preferences-over-outcomes
    JEL: B41 C83 D61 D62 H41 H43
    Date: 2017–02
  9. By: Brad R. Humphreys (West Virginia University, Department of Economics); Thomas J. Miceli (University of Connecticut, Department of Economics)
    Abstract: The classical Uncertainty of Outcome Hypothesis (UOH) informs economists’ understanding consumer decisions to attend sporting events and models of team revenue generation. Coates, Humphreys and Zhou (2014) developed a reference dependent preference based consumer choice model under uncertainty to motivate the UOH in which loss-averse consumers prefer games with certain outcomes. We develop an alternative model based on a standard expected utility model of fan behavior which incorporates fans’ decisions to travel to away games and aggregates decisions across local and visiting fans. This model generates predictions consistent with the classical UOH and concave team and league-wide total revenue functions.
    Keywords: outcome uncertainty, game attendance, aggregation, travel
    JEL: L83 D12 Z20
    Date: 2016–12
  10. By: Rui Pedro Brito (CeBER and Faculty of Economics of the University of Coimbra); Hélder Sebastião (CeBER and Faculty of Economics of the University of Coimbra); Pedro Godinho (CeBER and Faculty of Economics of the University of Coimbra)
    Abstract: In this paper we conduct an empirical analysis on the performance gains of using high frequency data in Portfolio Selection. Within a CRRA-utility maximization framework, we suggest the construction of two different portfolios: a low and a high frequency portfolio. For ten different risk aversion levels, we compare the performance of both portfolios in terms of several out-of-sample measures. Using data on fourteen stocks of the CAC 40 stock market index, from January 1999 to December 2003, we conclude that the “fight” is always “won” by the high frequency portfolio for all the considered performance evaluation measures.
    Keywords: portfolio selection, utility maximization criteria, higher moments, high frequency data, out-of-sample analysis.
    JEL: C44 C55 C58 C61 C63 C88 G11
    Date: 2017–02
  11. By: Jim Jin; Felix FitzRoy
    Abstract: We show that minimum wage earners should pay a lower tax than high earners. Though intuitive, this idea is not supported by the existing literature. The optimal maximin tax curve and two-band taxes are usually decreasing. Since decreasing marginal taxes would be unpopular, by continuity a flat tax seems to be superior to increasing marginal taxes and should be a second best solution. However, using a simple utility function and a general income distribution, we find that lowering the marginal tax for minimum wage earners not only dominates the optimal flat tax under maximin, but also make everyone better off.
    Keywords: flat tax, income redistribution, maximin, Pareto improvement
    JEL: H20 D60
    Date: 2017–02–16
  12. By: Yasuhiro Sakai (Faculty of Economics, Shiga University)
    Abstract: This paper aims to discuss the problem of nuclear power generation from the viewpoint of the economics of risk and uncertainty. Although we have experienced the two major nuclear disasters, Chernobyl and Fukushima, in recent times, it is quite unfortunate that risk-economic studies in nuclear power generation have been extremely rare so far. This may show intentional neglect in the academic circle. The purpose of this paper is to duly mend such a regrettable tendency. Before 11 March 2011, there were many people who more or less believed in the myth of absolute safety. The Great East Japan Earthquake, however, has completely changed their concept of risk for nuclear power generation, thus requiring the need to take a new risk-economic approach to nuclear energy. As saying goes, we can learn new lessons in old teachings: we have to reexamine the economics of J.M. Keynes and Frank Knight. There are many possibilities for future research.
    Keywords: Risk, uncertainty, nuclear power generation, Keynes, Knight
  13. By: Francesca Rondina (Department of Economics, University of Ottawa, Ottawa, ON)
    Abstract: This paper proposes a model uncertainty framework that accounts for the uncertainty about both the specification of the Phillips curve and the identification assumption to be used for parameter estimation. More specifically, the paper extends the framework employed by Cogley and Sargent (2005) to incorporate uncertainty over the direction of fit of the Phillips curve. I first study the evolution of the model posterior probabilities, which can be interpreted as a measure of the econometrician's real-time beliefs over the prevailing model of the Phillips curve. I then characterize the optimal policy rule within each model, and I analyze alternative policy recommendations that incorporate model uncertainty. As expected, different directions of fit of the same model of the Phillips curve imply very different optimal policy choices, with the “Classical” specifications typically suggesting low and stable optimal inflation rates. I also find that allowing rational agents to incorporate model uncertainty in their expectations does not change the optimal or robust policies. On the other hand, I show that the models' fit to the data and the robust policy recommendations are affected by the specific price index that is used to measure in inflation.
    Keywords: Phillips curve, Model Uncertainty, Robust Policy, Bayesian Model Averaging, Expectations
    JEL: C52 E37 E52 E58
    Date: 2017
  14. By: Luis Carlos Pupo Garcia; Jairo Parada Corrales
    Abstract: Los experimentos de elección constituyen a una herramienta poderosa para la construcción de escenarios hipotéticos que permitan identificar la utilidad que les genera a los usuarios potenciales la utilización de los bienes y servicios ambientales. En el presente trabajo se identifica el valor que los turistas potenciales de las ciudades de Bogotá, Medellín y Cali les asignan a los atributos medio ambientales asociados con la pesca deportiva, los recorridos por manglar y el avistamiento de ballenas, actividades que se desarrollan en el golfo de Tribugá (Chocó). En el estudio se aplicaron dos métodos de estimación diferentes, obteniéndose dos medidas de valor económico: con base en el método de valoración contingente (VC) de $276.081.466 anual y por el método de experimentos de elección (EE) de $188.930.000 anual. La disponibilidad a pagar marginal promedio por visita que estarían dispuestos a realizar los visitantes es de $1.850 y $1.296 para VC y EE, respectivamente. Estos hallazgos resultan importantes, debido a que es la primera valoración realizada en esta región, la cual servirá de insumo para la elaboración de estrategias para la generación de ingresos como estrategia de sostenibilidad financiera de un área marina protegida. ****** Choice experiments are a powerful tool for building hypothetical scenarios identifying the utility of potential users provided by the use of environmental goods and services. This paper is aimed at calculating the value that potential tourists, from the cities of Bogotá, Medellin and Cali, assign to environmental attributes related to recreational fishing, mangrove tours and whale watching activities taking place in the Gulf of Tribugá-Chocó. In order to carry out this study, we applied two different estimation methods, The Contingent Valuation (CV) which generated an average annual Willingness to Pay (WTP) of $276.081.466 for potential visitors and the Choice Experiments method (CE) with an annual value of $188.930.000. The marginal average annual WTP per visit was of $ 1.850 and $ 1.296 for CV and CE, respectively. These results are important because they are part of the first estimated economic valuation in this region, which will also serve as inputs for the development of strategies for income generation as a strategy on financial sustainability of a marine protected area.
    Keywords: Experimentos de elección, valoración contingente, área marina protegida., Choice experiments, contingentvaluation, marine protected area.
    JEL: H23 H41 Q57 D71
    Date: 2015–09–01
  15. By: Ketter, W.; Collins, J.; de Weerdt, M.M.
    Abstract: This is the specification for the Power Trading Agent Competition for 2017 (Power TAC 2017). Power TAC is a competitive simulation that models a “liberalized” retail electrical energy market, where competing business entities or “brokers” offer energy services to customers through tariff contracts, and must then serve those customers by trading in a wholesale market. Brokers are challenged to maximize their profits by buying and selling energy in the wholesale and retail markets, subject to fixed costs and constraints; the winner of an individual “game” is the broker with the highest bank balance at the end of a simulation run. Costs include fees for publication and withdrawal of tariffs, and distribution fees for transporting energy to their contracted customers. Costs are also incurred whenever there is an imbalance between a broker’s total contracted energy supply and demand within a given time slot. The simulation environment models a wholesale market, a regulated distribution utility, and a population of energy customers, situated in a real location on Earth during a specific period for which weather data is available. The wholesale market is a relatively simple call market, similar to many existing wholesale electric power markets, such as Nord Pool in Scandinavia or FERC markets in North America, but unlike the FERC markets we are modeling a single region, and therefore we approximate locational-marginal pricing through a simple manipulation of the wholesale supply curve. Customer models include households, electric vehicles, and a variety of commercial and industrial entities, many of which have production capacity such as solar panels or wind turbines. All have “real-time” metering to support allocation of their hourly supply and demand to their subscribed brokers, and all are approximate utility maximizers with respect to tariff selection, although the factors making up their utility functions may include aversion to change and complexity that can retard uptake of marginally better tariff offers. The distribution utility models the regulated natural monopoly that owns the regional distribution network, and is responsible for maintenance of its infrastructure. Real-time balancing of supply and demand is managed by a market-based mechanism that uses economic incentives to encourage brokers to achieve balance within their portfolios of tariff subscribers and wholesale market positions, in the face of stochastic customer behaviors and weather-dependent renewable energy sources. Changes for 2017 are focused on a more realistic wholesale market, reducing the market power of brokers by making the simulation scenario into a relatively small part of a larger market, and are highlighted by change bars in the margins. See Section 5.3 for details.
    Keywords: Autonomous Agents, Electronic Commerce, Energy, Preferences, Portfolio Management, Power, Policy Guidance, Sustainability, Trading Agent Competition
    Date: 2017–02–13
  16. By: Alserda, G.A.G.
    Abstract: The results of eliciting risk preferences depend on the elicitation method. Different methods of measuring the same variable tend to produce different results. This raises the question whether normative risk preferences can be elicited at all. Using two types of manipulation, I assess the normative value of risk preference elicitation methods. Following IRT, the results of the multiple lottery choice method are combined with two qualitative methods into a composite score. The responses of 9,235 pension fund members to a dedicated survey indicate this composite score approximates the latent variable normative risk preferences better than individual method responses do, substantially reducing measurement noise and method-specific biases. Analysis of the manipulations shows that both the results and the normative value of the risk preference elicitation methods depend on the specific amounts, order, and endowment chosen. Combining simpler methods with more advanced methods framed closely to the relevant situation increases the normative value of elicited risk preferences.
    Keywords: Normative Risk Preferences, Composite Score, Multiple Lottery Choice, Item Response Theory, Manipulations
    Date: 2017–02–07
  17. By: David S. Ahn (University of California, Berkeley); Ryota Iijima (Cowles Foundation, Yale University); Yves Le Yaouanq (Ludwig-Maximilians-Universitat); Todd Sarver (Duke University)
    Abstract: We propose nonparametric definitions of absolute and comparative naivete. These definitions leverage ex-ante choice of menu to identify predictions of future behavior and ex-post (random) choices from menus to identify actual behavior. The main advantage of our definitions is their independence from any assumed functional form for the utility function representing behavior. An individual is sophisticated if she is indifferent between choosing from a menu ex post or committing to the actual distribution of choices from that menu ex ante. She is naive if she prefers the flexibility in the menu, reflecting a mistaken belief that she will act more virtuously than she actually will. We propose two definitions of comparative naivete and explore the restrictions implied by our definitions for several prominent models of time inconsistency. Finally, we discuss the implications of general naivete for welfare and the design of commitment devices.
    Keywords: Naive, Sophisticated, Time inconsistent, Comparative statics
    JEL: D90
    Date: 2017–02
  18. By: Simon Schopohl (EDEEM - Université Paris 1, Universität Bielefeld and Université Catholique de Louvain)
    Abstract: We consider a Sender-Receiver game in which the Sender can choose between sending a cheap-talk message, which is costless, but also not verified and a costly verified message. While the Sender knows the true state of the world, the Receiver does not have this information, but has to choose an action depending on the message he receives. The action then yields to some utility for Sender and Receiver. We only make a few assumptions about the utility functions of both players, so situations may arise where the Sender's preferences are such that she sends a message trying to convince the Receiver about a certain state of the world, which is not the true one. In a finite setting we state conditons for full revelation, i.e. when the Receiver always learns the truth. Furthermore we describe the player's behavior if only partial revelation is possible. For a continuous setting we show that additional conditions have to hold and that these do not hold for “smooth” preferences and utility, e.g. in the classic example of quadratic loss utilities
    Keywords: cheap-talk; communication; costly disclosure; full revelation; increasing differences; Sender-Receiver game; verifiable information
    JEL: C72 D82
    Date: 2017–01
  19. By: Tobias Börger (School of Geography and Sustainable Development, University of St. Andrews); Oliver Frör (Institute of Environmental Sciences, University of Koblenz-Landau, Germany); Sören Weiß (Institute of Environmental Sciences, University of Koblenz-Landau, Germany)
    Abstract: Discrete choice experiments to value environmental goods and services constitute a complex and demanding task for survey respondents. This study looks at the effect of perceived difficulty with the choice tasks on choice consistency and preferences. The choice data come from two parallel surveys valuing river management outcomes in Germany. Results show that perceived difficulty decreases response scale, an indicator of the relative weight of the explained over the random component of indirect utility of a choice alternative. The reasons for this effect have more to do with the design of the actual task in the choice experiment than with the content and topic of the valuation exercise. Results also show only a very limited effect on preferences and willingness to pay for aspects of river management. The proposed econometric strategy manages to effectively separate the effect of difficulty on inter-individual differences of preference and scale. Based on these results, we recommend (i) to rigorously test the attribute design to allow only meaningful trade-offs as perceived by respondents and (ii)to put greater emphasis on the explanation of the choice tasks.
    Keywords: Discrete choice experiment, scale heterogeneity, perceived difficulty, river management
    JEL: H4 Q25 Q51
    Date: 2017–02

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