nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2017‒08‒27
ten papers chosen by

  1. The link between consumption and leisure under Cobb-Douglas preferences:Some new evidence By Brissimis, Sophocles N.; Bechlioulis, Alexandros P.
  2. Variance stochastic orders By Gollier, Christian
  3. Prospect Theory and Energy Efficiency By Garth Heutel
  4. Generalized Entropy and Model Uncertainty By Alexander Meyer-Gohde;
  5. Alternative Types of Ambiguity and their Effects on the Probabilistic Properties and Tail Risks of Environmental-Policy Variables By Phoebe Koundouri; Nikitas Pittis; Panagiotis Samartzis; Nikolaos Englezos; Andreas Papandreou
  6. The effectiveness of unconventional monetary policy on risk aversion and uncertainty By Leonidas S. Rompolis
  7. Costly decisions and sequential bargaining By James Costain
  8. Mispriced Index Option Portfolios By George M. Constantinides; Michal Czerwonko; Stylianos Perrakis
  9. Amgiguity Aversion, Modern Bayesianism and Small Worlds By Phoebe Koundouri; Nikitas Pittis; Panagiotis Samartzis; Nikolaos Englezos; Andreas Papandreou
  10. Arbitration and Renegotiation in Trade Agreements By Robert A. Becker; Juan Pablo Rincón-Zapatero

  1. By: Brissimis, Sophocles N.; Bechlioulis, Alexandros P.
    Abstract: The assumption of multiplicative non-separable (Cobb-Douglas) consumer preferences is a key assumption for analyzing the interdependence of consumption and leisure choices. In this paper we solve the consumer utility maximization problem under these preferences and derive a simultaneous system of two equations corresponding to a static and an inter-temporal equation of consumption and leisure choice. The system is estimated with GMM to obtain consistent estimates of the consumer's preference parameters, of which the relative weight of consumption in the utility function is found to be much higher than that commonly assumed in DSGE model calibration exercises.
    Keywords: Cobb-Douglas consumer preferences; consumption and leisure choices; GMM estimation; weight of consumption in utility
    JEL: C36 C61 D12 E44
    Date: 2017–07–27
  2. By: Gollier, Christian
    Abstract: Suppose that the decision-maker is uncertain about the variance of the payoff of a gamble, and that this uncertainty comes from not knowing the number of zero-mean i.i.d. risks attached to the gamble. In this context, we show that any n-th degree increase in this variance risk reduces expected utility if and only if the sign of the 2n-th derivative of the utility function u is (-1)n+1. Moreover, increasing the statistical concordance between the mean payoff of the gamble and the n-th degree riskiness of its variance reduces expected utility if and only if the sign of the 2n + 1 derivative of u is (-1)n+1. These results generalize the theory of risk apportionment developed by Eeckhoudt and Schlesinger (2006), and is useful to better understand the impact of stochastic volatility on welfare and asset prices.
    Keywords: Long-run risk; stochastic dominance; prudence; temperance; stochastic volatility; risk apportionment.
    JEL: D81
    Date: 2017–07
  3. By: Garth Heutel
    Abstract: Investments in energy efficiency entail uncertainty, and when faced with uncertainty consumers have been shown to behave according to prospect theory: preferences are reference-dependent and exhibit loss aversion, and probabilities are subjectively weighted. Using data from a choice experiment eliciting prospect theory parameters, I provide evidence that loss-averse people are less likely to invest in energy efficiency. Then, I consider policy design under prospect theory when there are also externalities from energy use. A higher degree of loss aversion implies a higher subsidy to energy efficiency. Numerical simulations suggest that the impact of prospect theory on policy may be substantial.
    JEL: D81 H23 Q41 Q58
    Date: 2017–08
  4. By: Alexander Meyer-Gohde;
    Abstract: I entertain a generalization of the standard Bolzmann-Gibbs-Shannon measure of entropy in multiplier preferences of model uncertainty. Using this measure, I derive a generalized exponential certainty equivalent, which nests the exponential certainty equivalent of the standard Hansen-Sargent model uncertainty formulation and the power certainty equivalent of the popular Epstein-Zin-Weil recursive preferences as special cases. Besides providing a model uncertainty rationale to these risk-sensitive preferences, the generalized exponential equivalent provides additional flexibility in modeling uncertainty through its introduction of pessimism into agents, causing them to overweight events made more likely in the worst case model when forming expectations. In a standard neoclassical growth model, I close the gap to the Hansen-Jagannathan bounds with plausible detection error probabilities using the generalized exponential equivalent and show that Hansen-Sargent and Epstein-Zin-Weil preferences yield comparable market prices of risk for given detection error probabilities.
    Keywords: model uncertainty; robust control; recursive preferences; equity premium puzzle; Tsallis entropy
    JEL: C61 C63 E17
    Date: 2017–08
  5. By: Phoebe Koundouri; Nikitas Pittis (University of Piraeus, Greece); Panagiotis Samartzis; Nikolaos Englezos; Andreas Papandreou
    Abstract: The concept of ambiguity with respect to decision making about climate change has recently attracted a lot of research interest. The standard approach for introducing ambiguity into this framework is to assume that the decision maker (DM) exhibits ambiguity aversion, with the latter being represented by axioms on DMs preferences different than Savageâ��s (sure-thing principle). As a result, DM is deprived of the property of probabilistic sophistication, since she is faced with either multiple prior probability functions, or a single but incoherent one (capacity). This paper approaches the issue of ambiguity with respect to climate change from a different perspective. In particular, we assume that ambiguity does exists but it does not affect the formation of DMs prior probability function. Instead, it a�¤ects the formation of her posterior probability function. Specifically, we assume that there are n experts, who supply DM with probabilistic input. Hence, although DM has a well defined prior (formed before any expert information on objective probabilities has arrived), she cannot decide which piece of information should conditionalize upon (defer to). We refer to this type of ambiguity as "deferential ambiguity" and show that it affects both DM and the experts. We also introduce a second type of ambiguity, which is solely born by the experts. This type of ambiguity stems from the experts potential inability to discern DMs preferences. This ambiguity is referred to as "preferential ambiguity" in the paper. The main objective of the paper is to analyze the possible interactions between the two types of ambiguity mentioned above and to assess their impact on the probabilistic properties (in particular, tail risks) of environmental-policy variables.
    Keywords: decision making on climate change, ambiguity, deep uncertainty, Savage�s sure-thing principle, deferential ambiguity, preferential ambiguity, tail risks of environmental-policy variables.
    JEL: D8 D80 D81 D83 D
    Date: 2017–08
  6. By: Leonidas S. Rompolis (Athens University of Economics and Business)
    Abstract: This paper examines the impact of unconventional monetary policy of ECB measured by its balance sheet expansion on euro area equity market uncertainty and investors risk aversion within a structural VAR framework. An expansionary balance sheet shock decreases both risk aversion and uncertainty at least in the medium-run. A negative shock on policy rates has also a negative impact on risk aversion and uncertainty. These results are generally robust to different specifications of the VAR model, estimation procedures and identification schemes. Conversely, periods of high uncertainty are followed by a looser conventional monetary policy. The effect of uncertainty on ECB’s total assets and of risk aversion on conventional or unconventional monetary policy is not always statistically significant.
    Keywords: Unconventional monetary policy; euro area; risk aversion; uncertainty
    JEL: C32 E44 E52 G12
    Date: 2017–07
  7. By: James Costain (Banco de España)
    Abstract: This paper models a near-rational agent who chooses from a set of feasible alternatives, subject to a cost function for precise decision-making. Unlike previous papers in the «control costs» tradition, here the cost of decisions is explicitly interpreted in terms of time. That is, by choosing more slowly, the decision-maker can achieve greater accuracy. Moreover, the timing of the choice is itself also treated as a costly decision. A trade off between the precision and the speed of choice becomes especially interesting in a strategic situation, where each decision maker must react to the choices of others. Here, the model of costly choice is applied to a sequential bargaining game. The game closely resembles that of Perry and Reny (1993), in which making an offer, or reacting to an offer, requires a positive amount of time. But whereas Perry and Reny treat the decision time as an exogenous fixed cost, here we allow the decision-maker to vary precision by choosing more or less quickly, thus endogenizing the order and timing of offers and responses in the game. Numerical simulations of bargaining equilibria closely resemble those of the Binmore, Rubinstein, and Wolinsky (1983) framework, except that the time to reach agreement is nonzero and offers are sometimes rejected. In contrast to the model of Perry and Reny, our numerical results indicate that equilibrium is unique when the space of possible offers is sufficiently finely spaced.
    Keywords: C72, C78, D81
    Date: 2017–08
  8. By: George M. Constantinides; Michal Czerwonko; Stylianos Perrakis
    Abstract: The optimal portfolio of a utility-maximizing investor trading in the S&P 500 index and cash, subject to proportional transaction costs, becomes stochastically dominated when overlaid with a zero-net-cost portfolio of S&P 500 options bought at their ask and written at their bid price in most months over 1990-2013. Dominance is prevalent when the ATM-IV is high, right skew is low, and option maturity is short. The portfolios include mostly calls and positions are overwhelmingly short. Similar results obtain with options on the CAC and DAX indices. The results are explained neither by priced factors nor a non-monotonic stochastic discount factor.
    JEL: G10 G11 G13 G23
    Date: 2017–08
  9. By: Phoebe Koundouri; Nikitas Pittis (University of Piraeus, Greece); Panagiotis Samartzis; Nikolaos Englezos; Andreas Papandreou
    Date: 2017–07
  10. By: Robert A. Becker (Indiana University); Juan Pablo Rincón-Zapatero (Univesidad Carlos III de Madrid)
    Abstract: We reconsider the theory of Thompson aggregators proposed by Marinacci and Montrucchio. First, we prove a variant of their Recovery Theorem estabilishing the existence of extremal solutions to the Koopmans equation. Our approach applies the constructive Tarski-Kantorovich Fixed Point Theorem rather than the nonconstructive Tarski Theorem employed in their paper. We verify the Koopmans operator has the order continuity property that underlies invoking Tarski-Kantorovich. Then, under more restrictive conditions, we demonstrate there is a unique solution to the Koopmans equation. Our proof is based on $u_{0}-$ concave operator techniques as first developed by Kransosels'kii. This differs from Marinacci and Montrucchio's proof as well as proofs given by Martins-da-Rocha and Vailakis.
    Keywords: Recursive Utility, Thompson Aggregators, Koopmans Equation, Extremal Solutions, Concave Operator Theory
    Date: 2017–07

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