nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2017‒05‒14
thirteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. A Tale of Two Tails: On the Coexistence of Overweighting and Underweighting of Rare Extreme Events By Epper, Thomas; Fehr-Duda, Helga
  2. A new behavioral framework to analyze preference construction and decision processes within the modal choice. By Hugo Bois
  3. Exploring the consistency of higher-order risk preferences By Haering, Alexander; Heinrich, Timo; Mayrhofer, Thomas
  4. Probability Weighting and Input Use Intensity in a State-Contingent Framework By Holden , Stein T.; Quiggin, John
  5. Disequilibrium as the origin, originality, and challenges of Clower's microfoundations of monetary theory By Plassard, Romain
  6. Risk as a limit or an opportunity to mitigate GHG emissions? The case of fertilisation in agriculture By Benjamin Dequiedt; Emmanuel Servonnat
  7. Zero time preference and eternal postponement of consumption By Pavel Potuzak
  8. Asymmetric dominance effect with multiple decoys for low- and high-variance lotteries By Sürücü, Oktay; Brangewitz, Sonja; Mir Djawadi, Behnud
  9. Intertemporal abatement decisions under ambiguity aversion in a cap and trade. By Simon Quemin
  10. Investing for the Long Run By Dietmar Leisen; Eckhard Platen
  11. Shadow prices for a small open economy under uncertainty: Which expected values are valid By Clive Bell
  12. A Just Price: Objections and Suggested Solutions By Lukas Maslo
  13. The Allocation and Valuation of Time By Diewert, Erwin; FOX, Kevin J.; Paul Schreyer

  1. By: Epper, Thomas; Fehr-Duda, Helga
    Abstract: Almost all important decisions in people’s lives entail risky consequences. Some of these decisions involve events that materialize with a low probability but lead to extreme consequences such as loss of total wealth or accidental death. When facing such rare extreme events, people display considerable risk aversion in some situations whereas in others the opposite is the case. For example, the prospect of airplane and stock market crashes triggers high risk aversion but there is a low willingness to take out hazard or life insurance. We address this puzzle by arguing that the timing of the consequences and of uncertainty resolution are crucial for understanding these phenomena. We show that future uncertainty conjointly with people’s proneness to probability distortions generates a unifying framework for explaining the coexistence of over- and underweighting of rare extreme events.
    Keywords: Tail risk, insurance, risk preference, time preferences, extreme events, probability weighting
    JEL: D01 D81 D91
    Date: 2017–04
  2. By: Hugo Bois
    Abstract: This paper discusses a new framework to explain the decision-making process of modal choice. A specific approach, based on the behavioral framework developed by Ben-Akiva & Boccara (1987), is adopted to understand and analyze the decision processes of individuals. Precisely, we use the Analytic Hierarchy Process (AHP) to build the hierarchy of preferences from attitudes and perceptions. Through the hierarchy of preferences, we can apply three different methods to better explain the decision processes; namely a standard compensatory model, a non-compensatory model based on the decision rules, and different possible weightings of the AHP method. The random utility maximization is predominantly used in the transportation literature because of its strong theoretical background, its success in predicting many types of human behavior, and the simplicity of mathematical and statistical analyses and model estimation it offers. Despite that, we believe that non-compensatory approaches are better suited to understand both travel behaviors and decision processes for transportation modes when taking active modes into account. These approaches allow us to better explain the impacts of each modal attribute on the one hand and to build psychological profiles with respect to decision rules on the other hand. Thus, it is possible to simulate shocks all things being equal.
    Keywords: Modal choice, Preferences, Decision rules, Hierarchical model, AHP.
    Date: 2016
  3. By: Haering, Alexander; Heinrich, Timo; Mayrhofer, Thomas
    Abstract: In this study we measure higher-order risk preferences and their consistency. We explore the role of country differences, the variation of stakes, and the framing of lotteries. We observe a robust dichotomous pattern of choice behavior in China, in the USA and in Germany. A large majority of choices is consistent with a preference for either (i) combining "good" outcomes with "bad" ones or (ii) combining "good" outcomes with "good" ones. We also find this pattern after a tenfold increase in the stakes. Finally, our results reveal that this pattern is strengthened if the lotteries are displayed in compound rather than reduced form. We explore potential explanations for this framing effect.
    Keywords: mixed risk aversion,prudence,temperance,higher-order risk preferences
    JEL: C91 D81
    Date: 2017
  4. By: Holden , Stein T. (Centre for Land Tenure Studies, Norwegian University of Life Sciences); Quiggin, John (School of Economics, University of Queensland)
    Abstract: Climate risk represents an increasing threat to poor and vulnerable farmers in drought-prone areas of Africa. This study assesses the fertilizer adoption responses of food insecure farmers in Malawi, where Drought Tolerant (DT) maize was recently introduced. A field experiment, eliciting risk attitudes of farmers, is combined with a detailed farm household survey. A state-contingent production model with rank-dependent utility preferences is estimated. Over-weighting of small probabilities was associated with less use of fertilizer on all maize types and particularly so on the more risky improved maize types.
    Keywords: Climate risk; state-contingent production; subjective probability weighting; technology adoption; adaptation; maize; Drought Tolerant maize; fertilizer use
    JEL: C93 D03 O33 Q12 Q18
    Date: 2017–05–05
  5. By: Plassard, Romain
    Abstract: Robert W. Clower’s article “A Reconsideration of the Microfoundations of Monetary Theory” (1967) deeply influenced the course of modern monetary economics. On the one hand, it questioned Don Patinkin’s (1956) project to integrate monetary and Walrasian value theory. On the other hand, it was the fountainhead of the cash-in-advance models à la Robert J. Lucas (1980), one of the most widely used approaches to monetary theory since the 1980s. Despite this influence, Clower’s (1967) project to integrate monetary and value theory remains an enigma. My paper intends to resolve it. This is a difficult task since Clower never completed the monetary theory outlined in his 1967 article. To overcome this difficulty, I characterize the intellectual context from which Clower’s (1967) contribution emerged and have recourse to a reconstruction of his project. This reconstruction is based on the analysis of published and unpublished materials, written by Clower before and after the 1967 article. It is argued that Clower (1967) sought to elaborate a disequilibrium monetary theory whilst retaining the two pillars of Patinkin’s integration, i.e., the introduction of money into utility functions and the real-balance effect. I trace the origins, account for the originality, and discuss the challenges of this project.
    Keywords: integration of monetary and value theory, microfoundations of macroeconomics, disequilibrium, Clower, Patinkin.
    JEL: B21 D46 D5
    Date: 2017–04
  6. By: Benjamin Dequiedt; Emmanuel Servonnat
    Abstract: In this paper, we investigate how risk and risk aversion influence the fertilisation behavior of farmers. We show analytically that a decreasing variance of yield along with nitrogen inputs encourages risk averse farmers to apply larger quantities of fertilizers compared with risk neutral behavior. Then, we use data concerning three departments in France (Deux-Sèvres, Seine-Maritime and Eure-et-Loir) to determine (i) crop yield response function to N fertilizers and (ii) risk aversion behavior of farmers on the basis of their actual fertilizers applications. We find that risk averse farmers represent 29,7% of farmers while risk seeking ones represent 35,5%. Risk aversion behavior is associated with an additional application of 29 kg/ha compared with risk neutral behavior which represents an average loss of 76 euros/ha. We show that the reduction of abatement linked to risk aversion behavior should appear only when crop yield variance is convex with respect to N fertilizers. Lastly, our results show that an insurance covering yield variability could be foreseen as an interesting tool to mitigate emissions.
    Keywords: Risk aversion, Emissions Tax, Mitigation Insurance, Fertilisation, Agriculture
    JEL: D81 D92 Q58
    Date: 2016
  7. By: Pavel Potuzak (University of Economics, Prague)
    Abstract: Ludwig von Mises in his magnum opus Human Action claimed that the absence of time preference would lead the consumer to postpone the act of consumption to indefinite future. Olson and Bailey (1981) demonstrated that zero time preference is consistent with positive real interest rate and positive present consumption if the marginal utility of consumption is rapidly decreasing and the income endowment is rising over time.This paper shows that zero time preference does not restrict present consumption to nil even if positive interest rate enables future consumption to be very large. Dynamic neoclassical model is applied to confirm that low intertemporal elasticity of substitution leads to positive present consumption even in the case of patient consumers. Determinants of the optimum present consumption are derived, and it is proved that labour income might not be increasing over time to confirm the approach of Olson and Bailey and to disprove the Mises theory.
    Keywords: time preference, Ludwig von Mises, postponement of consumption, intertemporal elasticity of substitution
    JEL: E21 B53 D90
    Date: 2017–04
  8. By: Sürücü, Oktay (Center for Mathematical Economics, Bielefeld University); Brangewitz, Sonja (Center for Mathematical Economics, Bielefeld University); Mir Djawadi, Behnud (Center for Mathematical Economics, Bielefeld University)
    Abstract: The asymmetric dominance effect refers to the phenomenon according to which the choice probability of an alternative increases when an inferior alternative - the decoy - is included into the choice set. The objective of this experimental study is twofold. First, we investigate the asymmetric dominance effect on two-outcome lotteries with almost equal expected values. We find that the impact of a decoy on low-variance lotteries (LVLs) is much higher than on high-variance lotteries (HVLs). Second, we examine the asymmetric dominance effect in the presence of two decoys. While the asymmetric dominance effect persists when the choice set includes two decoys, the effect is not always further enhanced compared to the setting with one decoy and again much stronger for LVLs than for HVLs. Controlling for subjects’ degrees of risk aversion, we find support for consistency between individual risk preferences and choice behavior among the lotteries. However, we observe decoy effects of equal strength irrespective of the subjects’ degree of risk aversion. Thus, our analysis indicates that to a substantial extent the presence of decoys subtly makes decision-makers choose against their risk preferences by favoring lotteries that entail risks contrary to their elicited individual risk-taking profile.
    Keywords: Asymmetric dominance effect, decoy effects, multiple decoys, risk aversion, individual decision making, experimental economics
    Date: 2017–05–02
  9. By: Simon Quemin
    Abstract: We study intertemporal abatement decisions by an ambiguity averse firm covered under a cap and trade. Ambiguity aversion is introduced to account for the prevalence of regulatory uncertainty in existing cap-and-trade schemes. Ambiguity bears on both the future permit price and the firm's demand for permits. Ambiguity aversion drives equilibrium choices away from intertemporal efficiency and induces two effects: a pessimistic distortion of beliefs that overemphasises 'detrimental' outcomes and a shift in the effective discount factor. Permit allocation is non neutral and the firm's intertemporal abatement decisions do not solely depend on expected future permit prices, but also on its own expected future market position. In particular, pessimism leads the expected net short (resp. long) firm to overabate (resp. underabate) early on relative to intertemporal efficiency. We show that there is a general incentive for early overabatement and that it is more pronounced under auctioning that under free allocation.
    Keywords: Emissions trading, Regulatory uncertainty, Permit banking, Ambiguity aversion.
    Date: 2017
  10. By: Dietmar Leisen; Eckhard Platen
    Abstract: This paper studies long term investing by an investor that maximizes either expected utility from terminal wealth or from consumption. We introduce the concepts of a generalized stochastic discount factor (SDF) and of the minimum price to attain target payouts. The paper finds that the dynamics of the SDF needs to be captured and not the entire market dynamics, which simplifies significantly practical implementations of optimal portfolio strategies. We pay particular attention to the case where the SDF is equal to the inverse of the growth-optimal portfolio in the given market. Then, optimal wealth evolution is closely linked to the growth optimal portfolio. In particular, our concepts allow us to reconcile utility optimization with the practitioner approach of growth investing. We illustrate empirically that our new framework leads to improved lifetime consumption-portfolio choice and asset allocation strategies.
    Date: 2017–05
  11. By: Clive Bell
    Abstract: This paper re-examines the validity of using expected values to evaluate the social profitability of public investments under uncertainty. Departing from the usual assumption of an aggregate good, the setting is a small open economy that faces stochastic world prices for tradable goods and productivity levels in domestic production. It is shown that the so-called ‘border price rule’—the vector of the shadow prices of traded goods is a scalar multiple of their world price vector—is, in general, invalid when the vector of mean world prices is used. The rule in that form is valid when the coefficient of risk aversion is 1. The error involved is small, however, even for values of that coefficient far from 1, including risk neutrality, when public expenditures are financed by lump-sum taxes. It is also small when preferences over goods are Cobb-Douglas and revenues are raised by taxing commodities. In contrast, using expected values to derive the shadow wage rate results in quite substantial errors when risk aversion is strong.
    Date: 2017
  12. By: Lukas Maslo (University of Economics, Prague)
    Abstract: This paper examines the concept of a just price not as a historical but as theoretical problem. After a detailed exposition of the scholastic theory of value, price and commutative justice, the author identifies four main subjective-value-based objections to the concept of a just price and settles them one after another. These objections are 1) an apparent self-contradiction consisting in stating a subjective nature of utility and, at the same time, equality of value in exchange; 2) how can a voluntary exchange be unjust; 3) how can a just price be found in an isolated exchange of a unique good; 4) a missing satisfactory definition of a just price. The author suggests to settle the first objection by identifying the ontological status of the objective value. Leaning on a distinction of an objective value in use (virtuositas) and subjective desirability (complacibilitas) made by Saint Bernardino of Sienna and Saint Antonino of Florence, the author asserts that while complacibilitas is a potentiality of subjective desirability resting in an individual, virtuositas is a potentiality of usefulness resting in a thing. On account of this, a following solution is suggested: a particular usefulness is not purely subjective because it does not depend on a subjective perception of an individual; it is a metaphysical accident of a thing, not a metaphysical accident of an individual; a particular usefulness is not purely objective, either, because it is a relation to an individua; thus, equality in exchange means equality of potentiality of usefulness which is not a particular usefulness but a set of all usefulnesses concealed in the potentiality of the thing, even though they have not yet been actuated. The author suggests to settle the second objection by providing a logical proof for the assertion that an exchange in which one party suffers an unjust price is not a voluntary exchange and, on the grounds of this, the author demonstrates that an unjust exchange cannot be a voluntary exchange. Finally, the author suggests a definition of a just price which is applicable to any exchange, whether a competitive price exists or not.
    Keywords: just price, commutative justice, value, potentiality, act, metaphysical accident, virtuositas, complacibilitas
    JEL: A12 B11 D46
    Date: 2017–04
  13. By: Diewert, Erwin; FOX, Kevin J.; Paul Schreyer
    Abstract: We provide a generalization of Becker's theory of the allocation of time. We assume that household time plays three roles: as leisure, household work and household labour supply, with separate utility valuations for each use of time. A case not considered by Becker, nor by Pollak and Wachter, is addressed; the case where the household does not provide external market labour. Various corner solutions to the household's time allocation problem are considered in detail, and we consider the econometric problems that these corner solutions create. We relate the analysis to the difficult problems associated with the valuation of household work at home.
    Keywords: Valuation of household time, replacement cost valuation of time, opportunity cost valuation of time, household production
    JEL: J22 E21 E01
    Date: 2017–05–04

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