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on Utility Models and Prospect Theory |
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Issue of 2017‒04‒23
seventeen papers chosen by |
| By: | Mel Win Khaw; Ziang Li; Michael Woodford |
| Abstract: | The theory of expected utility maximization (EUM) explains risk aversion as due to diminishing marginal utility of wealth. However, observed choices between risky lotteries are difficult to reconcile with EUM: for example, in the laboratory, subjects' responses on individual trials involve a random element, and cannot be predicted purely from the terms offered; and subjects often appear to be too risk averse with regard to small gambles (while still accepting sufficiently favorable large gambles) to be consistent with any utility-of-wealth function. We propose a unified explanation for both anomalies, similar to the explanation given for related phenomena in the case of perceptual judgments: they result from judgments based on imprecise (and noisy) mental representation of the decision situation. In this model, risk aversion is predicted without any need for a nonlinear utility-of-wealth function, and instead results from a sort of perceptual bias — but one that represents an optimal Bayesian decision, given the limitations of the mental representation of the situation. We propose a specific quantitative model of the mental representation of a simple lottery choice problem, based on other evidence regarding numerical cognition, and test its ability to explain the choice frequencies that we observe in a laboratory experiment. |
| JEL: | C91 D3 D81 D87 |
| Date: | 2017–03 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:23294&r=upt |
| By: | Christophe Courbage (Geneva School of Business Administration - University of Applied Sciences Western Switzerland); Henri Loubergé (University of Geneva [Switzerland]); Béatrice Rey (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 - UJM - Université Jean Monnet [Saint-Etienne] - Université de Lyon - CNRS - Centre National de la Recherche Scientifique) |
| Abstract: | This paper investigates how welfare losses for facing risks change as the risk environment of the decision-maker is altered. To that aim, we define the risk apportionment of order n (RAn) utility premium as a measure of pain associated with facing the passage from one risk to a riskier one. Changes in risks are expressed through the concept of stochastic dominance of order n. Three configurations of risk exposures are considered. The paper first shows how the RAn utility premium is modified when initial wealth becomes riskier. Second, the paper provides conditions on individual preferences for superadditivity of the RAn utility premium. Third, the paper investigates welfare changes of merging increases in risks. These results offer new interpretations of the sign of higher derivatives of the utility function. |
| Keywords: | risk apportionment, superadditivity, RA-n utility premium |
| Date: | 2017 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:halshs-01471888&r=upt |
| By: | Antonio Santos |
| Abstract: | This article builds on the mean-variance criterion and the links with the expected utility maximization to define the optimal allocation of portfolios, and extends the results in two ways, first considers tailored made utility functions, which can be non continuous and able to capture possible preferences associated with some portfolio managers. Second, it presents results that relate to static (myopic) portfolio allocation decisions connected to dynamic settings where multi-period allocations are considered and conditions are defined to rebalance the portfolio as new information arrive. The conditions are established for the compatibility of static and dynamic decisions associated with different utility functions. We model agents’ decisions associated with portfolio allocation within the expected utility maximization framework. We expect to link the common paradigm of the mean-variance criterion associated with myopic portfolio allocation problems with a more practical implementation of such decision problems, where non continuous utility functions and multi-period type of decisions can play an important role. |
| Keywords: | Portugal, Agent-based modeling, Optimization models |
| Date: | 2016–07–04 |
| URL: | http://d.repec.org/n?u=RePEc:ekd:009007:9375&r=upt |
| By: | Andries, Marianne; Haddad, Valentin |
| Abstract: | We propose a theory of inattention solely based on preferences, absent cognitive limitations or external costs of information. Under disappointment aversion, agents are intrinsically information averse. In a consumption-savings problem, we study how information averse agents cope with their fear of information, to make better decisions: they acquire information at infrequent intervals only, and inattention increases when volatility is high, consistent with the empirical evidence. Adding state-dependent alerts following sharp downturns improves welfare, despite the additional endogenous information costs. Our framework accommodates a broad range of applications, suggesting our approach can explain many observed features of decision under uncertainty. |
| Date: | 2017–03 |
| URL: | http://d.repec.org/n?u=RePEc:tse:wpaper:28621&r=upt |
| By: | Nicolas Gravel (Aix-Marseille Univ. (Aix-Marseille School of Economics), CNRS, EHESS and Centrale Marseille); Brice Magdalou (Lameta, Université de Montpellier); Patrick Moyes (GREThA, CNRS, Université de Bordeaux) |
| Abstract: | What would be the analogue of the Lorenz quasi-ordering when the variable of interest is of a purely ordinal nature? We argue that it is possible to derive such a criterion by substituting for the Pigou-Dalton transfer used in the standard inequality literature what we refer to as a Hammond progressive transfer. According to this criterion, one distribution of utilities is considered to be less unequal than another if it is judged better by both the lexicographic extensions of the maximin and the minimax, henceforth referred to as the leximin and the antileximax, respectively. If one imposes in addition that an increase in someone’s utility makes the society better off, then one is left with the leximin, while the requirement that society welfare increases as the result of a decrease of one person’s utility gives the antileximax criterion. Incidently, the paper provides an alternative and simple characterisation of the leximin principle widely used in the social choice and welfare literature. |
| Keywords: | ordinal inequality, Hammond equity axiom, leximin, antileximax |
| JEL: | D30 D63 I32 |
| Date: | 2017–01 |
| URL: | http://d.repec.org/n?u=RePEc:aim:wpaimx:1703&r=upt |
| By: | Soo Hong Chew (National University of Singapore); Junjian Yi (The University of Chicago); Junsen Zhang (Chinese University of Hong Kong); Songfa Zhong (National University of Singapore) |
| Abstract: | We study the role of risk aversion underlying son preference in patriarchal societies, where sons serve as better insurance for old-age support than daughters. The implications of an insurance motive on son preference are two-fold. First, prior to the birth of their children, more risk-averse parents have a stronger preference for sons than for daughters. Second, after the birth of their children, parents with sons are more risk seeking, compared to parents with daughters. We adopt a within-twin-pair fixed-effects estimator with a weak identification assumption, which enables us to jointly identify these two effects. We further conduct an incentivized choice experiment to assess parental risk attitude in a sample of Chinese twins with children, and follow up with a second twin sample to examine the replicability of the findings. In both samples, we find that parents with higher risk aversion before the birth of their children are more likely to have sons through sex selection than parents with lower risk aversion. Additionally, having sons significantly decreases parental risk aversion. These results contribute to the literature on the sources of son preference and help shed light on the nature of gender inequality. |
| Keywords: | risk aversion, son preference, twins, experimental economics |
| JEL: | C93 D10 D80 J13 |
| Date: | 2017–04 |
| URL: | http://d.repec.org/n?u=RePEc:hka:wpaper:2017-028&r=upt |
| By: | Victorien Barbet (Aix-Marseille Univ. (Aix-Marseille School of Economics), CNRS, EHESS and Centrale Marseille); Renaud Bourlès (Aix-Marseille Univ. (Aix-Marseille School of Economics), CNRS, EHESS and Centrale Marseille); Juliette Rouchier (LAMSADE, CNRS) |
| Abstract: | We study the dynamics of risk-sharing cooperatives among heterogeneous agents. Based of their knowledge on their risk exposure and the performance of the cooperatives, agents choose whether or not to remain in the risk-sharing agreement. We highlight the key role of other-regarding preferences, both altruism and inequality aversion, in stabilizing less segregated (and smaller) cooperatives. Limited knowledge and learning of own risk exposure also contributes to reducing segregation. Our finding shed light on the mechanisms behind risk-sharing agreements between agents heterogeneous in their risk exposure. |
| Keywords: | Agent-based, cooperative, risk-sharing, Learning, altruism, other-regarding preferences |
| Date: | 2017–02 |
| URL: | http://d.repec.org/n?u=RePEc:aim:wpaimx:1706&r=upt |
| By: | Dertwinkel-Kalt, Markus; Köster, Mats |
| Abstract: | We show that continuous models of stimulus-driven attention can account for skewness-related puzzles in decision-making under risk. First,we delineate that these models provide awell-defined theory of choice under risk. We therefore prove that in continuous - in contrast to discrete - models of stimulus-driven attention each lottery has a unique certainty equivalent that is monotonic in probabilities (i.e., it monotonically increases if probability mass is shifted to more favorable outcomes). Second, we show that whether an agent seeks or avoids a specific risk depends on the skewness of the underlying probability distribution. Since unlikely, but outstanding payoffs attract attention, an agent exhibits a preference for right-skewed and an aversion toward left-skewed risks. While cumulative prospect theory can also account for such skewness preferences, it yields implausible predictions on their magnitude. We show that these extreme implications can be ruled out for continuous models of stimulus-driven attention. |
| Keywords: | stimulus-driven attention,salience theory,focusing,certainty equivalent,monotonicity,skewness preferences |
| JEL: | D81 |
| Date: | 2017 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:dicedp:248&r=upt |
| By: | Mathieu Faure (Aix-Marseille Univ. (Aix-Marseille School of Economics), CNRS, EHESS and Centrale Marseille); Nicolas Gravel (Aix-Marseille Univ. (Aix-Marseille School of Economics), CNRS, EHESS and Centrale Marseille) |
| Abstract: | This paper establishes an equivalence between three incomplete rankings of distributions of income among agents that are vertically differentiated with respect to some other non-income characteristic (health, household size, etc.). The first ranking is that associated with the possibility of going from one distribution to the other by a finite sequence of income transfers from richer and more highly ranked agents to poorer and less highly ranked ones. The second ranking is the unanimity of all comparisons of two distributions made by a utilitarian planer who assumes that agents convert income into utility by the same function exhibiting a marginal utility of income that is decreasing with respect to both income and the source of vertical differentiation. The third ranking is the Bourguignon (1989) ordered poverty gap dominance criterion. |
| Keywords: | equalization, transfers, heterogenous agents, poverty gap, Dominance, utilitarianism |
| JEL: | D30 D63 I32 |
| Date: | 2017–01 |
| URL: | http://d.repec.org/n?u=RePEc:aim:wpaimx:1702&r=upt |
| By: | Jang-Ting Guo (Department of Economics, University of California Riverside); Yan Zhang (Shanghai University of Finance and Economics) |
| Abstract: | It has been analytically shown that under an additively separable preference formulation between consumption and hours worked, indeterminacy and sunspots may arise in a standard one-sector real business cycle model when the labor tax rate is endogenously determined by a balanced-budget rule with a pre-specified constant level of government expenditures. This paper finds that local indeterminacy disappears if the period utility function is postulated to exhibit no income effect on the household's demand for leisure. In particular, the model's low-tax steady state always displays saddle-path stability and equilibrium uniqueness; whereas the high-tax steady state is either a source or a saddle point. |
| Keywords: | Keywords: Income Effect; Balanced-Budget Rules; Indeterminacy; Business Cycles. |
| JEL: | E32 E62 |
| Date: | 2017–04 |
| URL: | http://d.repec.org/n?u=RePEc:ucr:wpaper:201704&r=upt |
| By: | Mathieu Faure (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille 2 - Université Paul Cézanne - Aix-Marseille 3 - EHESS - École des hautes études en sciences sociales - AMU - Aix Marseille Université - ECM - Ecole Centrale de Marseille - CNRS - Centre National de la Recherche Scientifique); Nicolas Gravel (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille 2 - Université Paul Cézanne - Aix-Marseille 3 - EHESS - École des hautes études en sciences sociales - AMU - Aix Marseille Université - ECM - Ecole Centrale de Marseille - CNRS - Centre National de la Recherche Scientifique) |
| Abstract: | This paper establishes an equivalence between three incomplete rankings of distributions of income among agents that are vertically differentiated with respect to some other non-income characteristic (health, household size, etc.). The first ranking is that associated with the possibility of going from one distribution to the other by a finite sequence of income transfers from richer and more highly ranked agents to poorer and less highly ranked ones. The second ranking is the unanimity of all comparisons of two distributions made by a utilitarian planer who assumes that agents convert income into utility by the same function exhibiting a marginal utility of income that is decreasing with respect to both income and the source of vertical differentiation. The third ranking is the Bourguignon (1989) ordered poverty gap dominance criterion. |
| Keywords: | equalization,transfers,heterogenous agents,poverty gap,dominance,utilitarianism |
| Date: | 2017–01 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:halshs-01430195&r=upt |
| By: | Dirk Becherer; Klebert Kentia |
| Abstract: | We study robust notions of good-deal hedging and valuation under combined uncertainty about the drifts and volatilities of asset prices. Good-deal bounds are determined by a subset of risk-neutral pricing measures such that not only opportunities for arbitrage are excluded but also deals that are too good, by restricting instantaneous Sharpe ratios. A non-dominated multiple priors approach to model uncertainty (ambiguity) leads to worst-case good-deal bounds. Corresponding hedging strategies arise as minimizers of a suitable coherent risk measure. Good-deal bounds and hedges for measurable claims are characterized by solutions to second-order backward stochastic differential equations whose generators are non-convex in the volatility. These hedging strategies are robust with respect to uncertainty in the sense that their tracking errors satisfy a supermartingale property under all a-priori valuation measures, uniformly over all priors. |
| Date: | 2017–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1704.02505&r=upt |
| By: | Billur Aksoy (Texas A&M University, Department of Economics); Haley Harwell (University of Richmond, Jepson School of Leadership Studies); Ada Kovaliukaite (Texas A&M University, Department of Economics); Catherine Eckel (Texas A&M University, Department of Economics) |
| Abstract: | We reinvestigate the question first posed by Glaeser, Laibson, Scheinkman and Soutter (2000, GLSS hereafter): What is the best measure of trust for predicting trusting behavior? This important study, cited over 2,100 times, established that the behavior in the investment game, an incentivized measure of trust, is not correlated with the responses to the most widely used survey questions about trust, employed in the General Social Survey (GSS) and the World Values Survey (WVS). We use the GLSS protocol with one major change: we employ the original Berg et al. (1995) investment game instead of the modified version used in GLSS. The standard game endows both players, while the latter endows only the first mover, potentially changing the incentives that influence subjects’ behavior. In particular, the utility from trusting behavior for inequality averse individuals may be higher, if the second movers are not endowed. Thus, such players may appear to be more trusting even though they are simply inequality averse. This causes a distortion in the laboratory measure of trust and reduces its correlation with the survey measure of trust. In support of this concern, GLSS demonstrates that the survey measure of trust is not correlated with trusting behavior in their investment game, where the second mover is not endowed. After endowing the second mover, we find the opposite. Our finding suggests that trust is a single construct, whether measured by the survey questions or by an incentivized game. This can be masked if the incentivized measure of trust is confounded with other motives. |
| Keywords: | Investment game, replication, lab experiment, trust, trustworthiness, inequality aversion |
| JEL: | C91 D64 |
| Date: | 2017–01–19 |
| URL: | http://d.repec.org/n?u=RePEc:txm:wpaper:20170119-001&r=upt |
| By: | Emmanuelle Augeraud-Véron (Mathématiques, Image et Applications (MIA), Université de La Rochelle); Giorgio Fabbri (Aix-Marseille Univ. (Aix-Marseille School of Economics), CNRS, EHESS and Centrale Marseille); Katheline Schubert (Paris School of Economics, Université Paris 1 Panthéon-Sorbonne) |
| Abstract: | This paper presents a benchmark endogenous growth model including biodiversity preservation dynamics. Producing food requires land, and increasing the share of total land devoted to farming mechanically reduces the share of land devoted to biodiversity conservation. However, the safeguarding of a greater number of species is associated to better ecosystem services – pollination, flood control, pest control, etc., which in turn ensure a lower volatility of agricultural productivity. The optimal conversion/preservation rule is explicitly characterized, as well as the value of biological diversity, in terms of the welfare gain of biodiversity conservation. The Epstein-Zin-Weil specification of the utility function allows us to disentangle the effects of risk aversion and aversion to fluctuations. A two-player game extension of the model highlights the effect of volatility externalities and the Paretian sub-optimality of the decentralized choice. |
| Keywords: | collective decibiodiversity, stochastic endogenous growth, insurance value, recursive preferences |
| JEL: | Q56 Q58 Q10 Q15 O13 O20 C73 |
| Date: | 2017–03 |
| URL: | http://d.repec.org/n?u=RePEc:aim:wpaimx:1709&r=upt |
| By: | JongRoul Woo; Christopher L. Magee |
| Abstract: | It is now clear that different technological domains have significantly different rates of performance improvement. Theoretically, such differing rates should influence the relative rate of diffusion of the products since improvement in performance during the diffusion process increases the desirability of the product diffusing. However, there has not been a broad empirical attempt to examine this effect and to explain the underlying cause. Therefore, this paper reviews the theoretical basis and focuses upon empirical tests of this effect and its underlying cause. The results for 18 different diffusing products show the expected relationship-faster diffusion for more rapidly improving products- between technological improvement and diffusion with strong statistical significance. The empirical examination also demonstrates that performance improvement does not slow down in the latter parts of diffusion when penetration does slow down. This finding is also consistent with theories of diffusion based upon utility but not with ideas that explain performance increases as due to competition among firms. |
| Date: | 2017–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1704.03597&r=upt |
| By: | Miguel Ferreira; José Tavares; Luís Catela Nunes |
| Abstract: | Our paper evaluates the relative importance of contagion and investors' risk aversion in determining sovereign debt yield during the fi nancial crisis in Europe. In the existing literature, pure contagion and investors risk aversion are often treated as indistinguishable, a possibly signifi cant conceptual shortcoming. In this paper we distinguish the impact of both variables on sovereign yields and clarify which had a more important role in the spread of financial crisis through Eurozone countries. We define risk aversion as the variations in the price of risk, extracted from the CDS spreads. Contagion, on the other hand, is defined as the increased probability of a bank defaulting given that another bank defaults. Default corresponds to the value of the asset value falling below a certain threshold, and the probability of default extracted from a probability density function estimated using CDS spreads. To test the impact of contagion and risk aversion on sovereign yields we employ a T-GARCH methodology to correct for the heteroscedasticity and to account for the fact that variance is asymmetrically dependent on the residuals. We fi nd that risk aversion, and not contagion, is the main culprit for the widening of yield spreads between South and Central European countries. The importance of risk aversion is con firmed by reactions to the Greek, Portuguese and Spanish bailouts. |
| Keywords: | Germany, Portugal, Spain, Italy, Greece, Austria, France and Belgium, Finance, Public finance |
| Date: | 2016–07–04 |
| URL: | http://d.repec.org/n?u=RePEc:ekd:009007:9617&r=upt |
| By: | Sevgi Coskun |
| Abstract: | The aim of this study is to explore the labor market properties of business cycle fluctuations for a group of 17 developing economies from 1970 to 2013 and compare these results to findings from the USA. Then, we build 7 RBC models without nominal frictions driven by temporary and permanent shocks following Aguiar and Gopinath (2007) to explain whether real business cycle models can successfully account for the labor market properties of business cycle fluctuations in these economies. Lastly, we would like to understand the fluctuations of labor wedge are mostly coming from the fluctuations of the household component of labor wedge or the fluctuations of the firm component of labor wedge in these economies. First, we would like to look at the performance of the most standard basic frictionless business cycle model driven by permanent and temporary shocks in terms of labor market moments. Then, we would like to see the performance of RBC model augmented capacity utilization, investment adjustment cost and indivisible labor using the same shocks and using both non-separable and separable utility functions. Preliminary Results: We have found that business cycle volatility is significantly higher in developing countries than in the USA. We figure also out that our models fail to generate the properties of labor market in these economies but RBC model with investment adjustment cost doing the best job among others. Lastly, we found that the most of the fluctuations comes from the fluctuations of the household component of labor wedge in developing countries. |
| Keywords: | United Kingdom, General equilibrium modeling, Developing countries |
| Date: | 2016–07–04 |
| URL: | http://d.repec.org/n?u=RePEc:ekd:009007:9732&r=upt |