nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2017‒10‒01
twenty-one papers chosen by

  1. Choice-Based Cardinal Utility: a tribute to Patrick Suppes By Jean Baccelli; Philippe Mongin
  2. Discrete Choice and Rational Inattention: a General Equivalence Result By Mogens Fosgerau; Emerson Melo; Andre de Palma; Matthew Shum
  3. Sequential equilibrium without rational expectations of prices: A theorem of full existence By Lionel de Boisdeffre
  4. Convergence of utility indifference prices to the superreplication price in a multiple-priors framework By Romain Blanchard; Laurence Carassus
  5. Fair Utilitarianism By Marc Fleurbaey; Stéphane Zuber
  6. The Demand and Supply of Favours in Dynamic Relationships By Jean Guillaume Forand; Jan Zapal
  7. The Demand for Money for EMU: A Flexible Functional Form Approach By William Barnett; Neepa B. Gaekwad
  8. Cognitive Ability and Bidding Behavior in Second Price Auctions: An Experimental Study By Lee, Ji Yong; Nayga, Rodolfo; Deck, Cary; Drichoutis, Andreas C.
  9. Option Pricing with Greed and Fear Factor: The Rational Finance Approach By Svetlozar Rachev; Frank J. Fabozzi; Boryana Racheva-Iotova
  10. Bayesian versus Heuristic-Based Choice under Sleep Restriction and Suboptimal Times of Day By Dickinson, David L.; McElroy, Todd
  11. Kinetic models for goods exchange in a multi-agent market By Carlo Brugna; Giuseppe Toscani
  12. Better response dynamics and Nash equilibrium in discontinuous games By Kukushkin, Nikolai S.
  13. Regret Aversion, Regret Neutrality, and Risk Aversion in Production By Xu GUO; Wing-Keung WONG
  14. Indifference or indecisiveness: a strict discrimination By Qiu, Jianying; Ong, Qiyan
  15. Free to Choose: Testing the Pure Motivation Effect of Autonomous Choice By Tomas Sjöström; Levent Ülkü; Radovan Vadovic
  16. Does Reminding of Behavioural Biases Increase Returns from Financial Trading? A Field Experiment By De Paola, Maria; Gioia, Francesca; Piluso, Fabio
  17. Relative Nash Welfarism By Yves SPRUMONT
  18. Strategyproof Choice of Acts : Beyond Dictatorship By Eric BAHEL; Yves SPRUMONT
  19. L'analyse axiomatique et l'attitude par rapport au risque By Jean Baccelli
  20. Preference purification and the inner rational agent: a critique of the conventional wisdom of behavioural welfare economics By Gerardo Infante; Guilhem Lecouteux; Robert Sugden
  21. Nonparametric Analysis of Random Utility Models By Yuichi Kitamura; J\"org Stoye

  1. By: Jean Baccelli (THEMA - Théorie économique, modélisation et applications - Université de Cergy Pontoise - CNRS - Centre National de la Recherche Scientifique, IHPST - Institut d'Histoire et de Philosophie des Sciences et des Techniques - UP1 - Université Panthéon-Sorbonne - ENS Paris - École normale supérieure - Paris - CNRS - Centre National de la Recherche Scientifique); Philippe Mongin (GREGH - Groupement de Recherche et d'Etudes en Gestion à HEC - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique, IHPST - Institut d'Histoire et de Philosophie des Sciences et des Techniques - UP1 - Université Panthéon-Sorbonne - ENS Paris - École normale supérieure - Paris - CNRS - Centre National de la Recherche Scientifique)
    Abstract: We reexamine some of the classic problems connected with the use of cardinal utility functions in decision theory, and discuss Patrick Suppes' contributions to this field in light of a reinterpretation we propose for these problems. We analytically decompose the doctrine of ordinalism, which only accepts ordinal utility functions, and distinguish between several doctrines of cardinalism, depending on what components of ordinalism they specifically reject. We identify Suppes' doctrine with the major deviation from ordinalism that conceives of utility functions as representing preference differences, while being nonetheless empirically related to choices. We highlight the originality, promises and limits of this choice-based cardinalism.
    Keywords: ordinalism, Suppes, representation theorems, preference differences, cardinalism,ordinal utility, cardinal utility
    Date: 2016
  2. By: Mogens Fosgerau; Emerson Melo; Andre de Palma; Matthew Shum
    Abstract: This paper establishes a general equivalence between discrete choice and rational inattention models. Matejka and McKay (2015, AER) showed that when information costs are modelled using the Shannon entropy function, the resulting choice probabilities in the rational inattention model take the multinomial logit form. By exploiting convex-analytic properties of the discrete choice model, we show that when information costs are modelled using a class of generalized entropy functions, the choice probabilities in any rational inattention model are observationally equivalent to some additive random utility discrete choice model and vice versa. Thus any additive random utility model can be given an interpretation in terms of boundedly rational behavior. This includes empirically relevant specifications such as the probit and nested logit models.
    Date: 2017–09
  3. By: Lionel de Boisdeffre (Centre d'Economie de la Sorbonne)
    Abstract: We consider a pure exchange economy, where agents, typically asymmetrically informed, exchange commodities, on spot markets, and securities of all kinds, on incomplete financial markets with no model of how future prices are determined. They have private characteristics, anticipations and beliefs. We show they face an incompressible uncertainty, represented by a so-called “minimum uncertainty set”, typically adding to the ‘exogenous uncertainty’, on tomorrow's state of nature, an ‘endogenous uncertainty’ on future spot prices, which may depend on every agent's private anticipations today. At equilibrium, all agents expect the ‘true’ price, in each realizable state, as a possible outcome, and elect optimal strategies, ex ante, which clear on all markets, ex post. Our main Theorem states that equilibrium exists as long as agents' prior anticipations, which may be refined from observing markets, embed that minimum uncertainty set. This result is stronger than the classical ones of generic existence, along Radner (1979), or Hart (1975), based on the rational expectations of prices
    Keywords: sequential equilibrium; temporary equilibrium; perfect foresight; existence; rational expectations; financial markets; asymmetric information; arbitrage
    JEL: D52
    Date: 2017–07
  4. By: Romain Blanchard; Laurence Carassus
    Abstract: This paper formulates an utility indifference pricing model for investors trading in a discrete time financial market under non-dominated model uncertainty. The investors preferences are described by strictly increasing concave random functions defined on the positive axis. We prove that under suitable conditions the multiple-priors utility indifference prices of a contingent claim converge to its multiple-priors superreplication price. We also revisit the notion of certainty equivalent for random utility functions and establish its relation with the absolute risk aversion.
    Date: 2017–09
  5. By: Marc Fleurbaey (Woodrow Wilson School and Center for Human Values - Princeton University); Stéphane Zuber (Centre d'Economie de la Sorbonne - Paris School of Economics)
    Abstract: Utilitarianism plays a central role in economics, but there is a gap between theory, where it is dominant and applications, where monetary criteria are often used. For applications, a key difficulty for utilitarianism remains to define how utilities should be measured and compared across individuals. Drawing on Harsanyi's approach (Harsanyi, 1955) involving choices in risky situations, we introduce a new normalization of utilities that is the only one ensuring that: 1) a transfer from a rich to a poor is welfare enhancing, and 2) populations with more risk averse people have lower welfare. We embed these requirements in a new characterization of utilitarianism and study some implications of this "fair utilitarianism" for risk sharing, collective risk aversion and the design of health policy
    Keywords: Fairness; social risk; utilitarianism
    JEL: D63 D81
    Date: 2017–01
  6. By: Jean Guillaume Forand; Jan Zapal
    Abstract: We characterise the optimal demand and supply of favours in a dynamic principal-agent model of joint production, in which heterogenous project opportunities arrive stochastically and are publicly observed upon arrival, utility from these projects is non-transferable and commitment to future production is limited. Our results characterise the optimal dynamic contract, and we establish that the principal's supply of favours (the production of projects that benefit the agent but not the principal) is backloaded, that the principal's demand for favours (the production of projects that benefit the principal but not the agent) is frontloaded, and that the production of projects is ordered by their comparative advantage, that is, by their associated efficiency in extracting (for demanded projects) and providing (for supplied projects) utility to the agent. Furthermore, we provide an exact construction of the optimal contract when project opportunities follow a Markov process.
    Keywords: dynamic contracts; trading favours; team production
    JEL: D86 C73 L24
    Date: 2017–09
  7. By: William Barnett (Department of Economics, The University of Kansas; Center for Financial Stability, New York City; IC2 Institute, University of Texas at Austin); Neepa B. Gaekwad (Department of Economics, The University of Kansas;)
    Abstract: Monetary aggregates have a special role under the "two pillar strategy" of the ECB. Hence, the need for a theoretically consistent measure of monetary aggregates for the European Monetary Union (EMU) is needed. This paper analyzes aggregation over monetary assets for the EMU. We aggregate over the monetary services for the EMU-11 countries, which include Estonia, Finland, France, Germany, Ireland, Italy, Luxembourg, Malta, Netherlands, Slovakia, and Slovenia. We adopt the Divisia monetary aggregation approach, which is consistent with index number theory and microeconomic aggregation theory. The result is a multilateral Divisia monetary aggregate in accordance with Barnett (2007). The multilateral Divisia monetary aggregate for the EMU-11 is found to be more informative and a better signal of economic trends than the corresponding simple sum aggregate. We then analyze substitutability among monetary assets for the EMU-11 within the framework of a representative consumer's utility function, using Barnett’s (1983) locally flexible functional form, the minflex Laurent Indirect utility function. The analysis of elasticities with respect to the asset’s user-cost prices shows that: (i) transaction balances (TB) and deposits redeemable at notice (DRN) are income elastic, (ii) the DRN display large variation in price elasticity, and (iii) the monetary assets are not good substitutes for each other within the EMU-11. Simple sum monetary aggregation assumes that component assets are perfect substitutes. Hence simple sum aggregation distorts measurement of the monetary aggregate. The ECB has Divisia monetary aggregates provided to the Governing Council at its meetings, but not to the public. Our European Divisia monetary aggregates will be expanded and refined, in collaboration with Wenjuan Chen at the Humboldt University of Berlin, to a complete EMU Divisia monetary aggregates database to be supplied to the public by the Center for Financial Stability in New York City.
    Keywords: Divisia monetary aggregation, European Monetary Union, monetary aggregation theory, multilateral aggregation, minflex Laurent, elasticities of demand.
    JEL: C43 C82 D12 E51 F33
    Date: 2017–09
  8. By: Lee, Ji Yong; Nayga, Rodolfo; Deck, Cary; Drichoutis, Andreas C.
    Abstract: Behavioral biases are more pronounced for individuals with lower cognitive abilities. This paper examines what connection if any there is between cognitive ability and bidding strategy in second price auctions. Despite truthful revelation being a weakly dominant strategy, previous experiments have consistently observed overbidding, which makes use of such auctions for inferring homegrown value problematic. Examining the effect of cognitive ability is important as it may help identify when one can reliably recover values from bids. The results indicate that more cognitively able subjects behave in closer accordance with theory, and that cognitive ability partially explains heterogeneity in bidding behavior.
    Keywords: Cognitive ability; Second price auction; Bid deviation; Overbidding; Laboratory experiment
    JEL: C91 C92
    Date: 2017–09–19
  9. By: Svetlozar Rachev; Frank J. Fabozzi; Boryana Racheva-Iotova
    Abstract: We explain the main concepts of Prospect Theory and Cumulative Prospect Theory within the framework of rational dynamic asset pricing theory. We derive option pricing formulas when asset returns are altered with a generalized Prospect Theory value function or a modified Prelec weighting probability function and introduce new parametric classes for Prospect Theory value functions and weighting probability functions consistent with rational dynamic pricing Theory. We study the behavioral finance notion of greed and fear from the point of view of rational dynamic asset pricing theory and derive the corresponding option pricing formulas in the case of asset returns that follow continuous diffusion or discrete binomial trees.
    Date: 2017–09
  10. By: Dickinson, David L. (Appalachian State University); McElroy, Todd (Florida Gulf Coast University)
    Abstract: This paper examines the impact of a commonly experienced adverse cognitive state on decision making under uncertainty. Specifically, we administer an at-home sleep restriction protocol combined with random assignment to the time-of-day for decision making. Thus, we induce sleepiness in our subjects via sleep restriction as well as suboptimal time-of-day prior to administration of a Bayesian choice task. The specific task used discriminates between Bayesian choices that coincide with more simple reinforcement heuristic choices (in "Easy" trials) versus those that do not (in "Hard" trials), which is ideal given our underlying hypothesis that sleepy subjects are more likely to use simple heuristics. We first show that both circadian mismatch and sleep restriction significantly increase subjective sleepiness – this documents protocol validity. Our key behavioral results are that sleepy subjects are more likely to make a Bayesian inaccurate decision and more likely to make decisions consistent with a simple reinforcement heuristic, particularly in more cognitively difficult "Hard" trials. Secondary results show that stimulation of subject affect increased used of the simple decision heuristic but, when combined with sleep restriction, increased affect may increase task motivation and improve choice accuracy. These results offer new insights into the likely impact of sleepiness on decision making under uncertainty and highlight the potential negative impact on such cognitive states may have on accurate formation of probability assessments.
    Keywords: sleep restriction, sleep deprivation, reinforcement heuristic, Bayesian choice, experiments
    JEL: C91 D81 D91
    Date: 2017–09
  11. By: Carlo Brugna; Giuseppe Toscani
    Abstract: We introduce a system of kinetic equations describing an exchange market consisting of two populations of agents (dealers and speculators) expressing the same preferences for two goods, but applying different strategies in their exchanges. We describe the trading of the goods by means of some fundamental rules in price theory, in particular by using Cobb-Douglas utility functions for the exchange. The strategy of the speculators is to recover maximal utility from the trade by suitably acting on the percentage of goods which are exchanged. This microscopic description leads to a system of linear Boltzmann-type equations for the probability distributions of the goods on the two populations, in which the post-interaction variables depend from the pre-interaction ones in terms of the mean quantities of the goods present in the market. In this case, it is shown analytically that the strategy of the speculators can drive the price of the two goods towards a zone in which there is a marked utility for their group. Also, the general system of nonlinear kinetic equations of Boltzmann type for the probability distributions of the goods on the two populations is described in details. Numerical experiments then show how the policy of speculators can modify the final price of goods in this nonlinear setting.
    Date: 2017–09
  12. By: Kukushkin, Nikolai S.
    Abstract: Philip Reny's approach to games with discontinuous utility functions can work outside its original context. The existence of Nash equilibrium and the possibility to approach the equilibrium set with a finite number of individual improvements are established, under conditions weaker than the better reply security, for three classes of strategic games: potential games, games with strategic complements, and aggregative games with appropriate monotonicity conditions.
    Keywords: discontinuous game; potential game; Bertrand competition; strategic complements; aggregative game
    JEL: C72
    Date: 2017–09–19
  13. By: Xu GUO (School of Statistics, Beijing Normal University, Beijing.); Wing-Keung WONG (Department of Finance and Big Data Research Center, Asia University; Department of Economics and Finance, Hang Seng Management College; Department of Economics, Lingnan University)
    Abstract: Previous studies focus on the comparison of the optimal output levels of regret-averse firms under uncertainty and firms under certainty. This paper extends the theory by investigating the effects of both regret-aversion and regret-neutrality on production. We compare the optimal output levels of both regret-averse and regret-neutral firms with purely risk-averse firms under uncertainty and firms under certainty. We first show that the regret-neutral ?rms will surely produce more than its purely risk-averse counterparts and surely produce less than firms under certainty. Thereafter, we give sufficient conditions to ensure the regret-averse firms to produce more than both purely risk-averse and regret-neutral counterparts and study the comparative statics of the optimal production. We also develop properties of regret aversion on production in a binary model. The finding in this paper is useful for production managers in their decision on the production.
    Keywords: Production; Regret aversion; Regret neutrality; Risk aversion; Regret theory; Uncertainty.
    JEL: D21 D24 D81
    Date: 2017–09
  14. By: Qiu, Jianying; Ong, Qiyan
    Abstract: Abstract We develop a new approach to directly and strictly distinguish indecisiveness from indifference. In our approach experimental subjects face a list of pairs of options. Besides the standard choice of choosing one option out of the pair (the binary choice), we also allow experimental subjects to randomize over the two options by choosing probabilities according to which either option determines the payoffs (the randomized choice). Furthermore, we elicit subjects' willingness to pay (WTP) of using the randomized choice via a modified multiple price list method. We show that subjects might strictly prefer the randomized choice over the binary choice when they are indecisive. Our results suggest that (1) the vast majority of subjects randomized actively; (2) subjects took longer time to make strictly randomized decisions; (3) subjects were willing to pay a strictly positive amount of money to randomize, and they were willing to pay more for randomized choices with randomizing probabilities close to 0.5 than those with randomizing probabilities close to 0 or 1. These results provide strong evidence for the existence of indecisiveness in choices. More importantly, it suggests that there might exist significant welfare losses when indecisive individuals are forced to make all-or-nothing decisions against their potentially incomplete preferences.
    Keywords: indecisiveness, indifference, experiment, randomized choices
    JEL: C9 C91 D81
    Date: 2017–05–01
  15. By: Tomas Sjöström (Department of Economics, Rutgers University); Levent Ülkü (Department of Economics, Instituto Tecnológico Autónomo de México); Radovan Vadovic (Department of Economics, Carleton University)
    Abstract: We conduct an experimental test of the long-standing conjecture that autonomy increases motivation and job performance. Subjects face a menu consisting of two projects: one risky and one safe. The probability that the risky project succeeds depends on the subject’s e?ort. In one treatment, subjects choose a project from the menu; in the other treatment, they are assigned a project from the menu. Using a di?erence-in-di?erence approach that controls for selection e?ects, we show that autonomy (the right to choose a project) has a signi?cant pure motivation e?ect on e?ort. The e?ect is consistent with aversion to anticipated regret, but not with standard expected-utility maximization. Futher, as predicted by regret theory, e?ort on the (chosen) risky project is increasing in the return to the (unchosen) safe project, and the pure motivation e?ect is greater, the riskier is the risky project. Finally, we ?nd a signi?cant negative relationship between the strength of the pure motivation e?ect and the subjects’ expected earnings. Classification-
    Date: 2017–09–18
  16. By: De Paola, Maria (University of Calabria); Gioia, Francesca (University of Edinburgh); Piluso, Fabio (University of Calabria)
    Abstract: We ran a field experiment to investigate whether nudge policies, consisting in behavioural insight messaging, help to improve performance in financial trading. Our experiment involved students enrolled in a financial trading course in an Italian University who were invited to trade on Borsa Italiana's virtual platform. Students were randomly assigned to a control group and a treatment group. Treated students received a message reminding them of the existence of behavioural biases in financial trading. We find that treated students significantly improve the performance of their portfolio. Several behaviours may explain the increase in performance. We find evidence pointing to a reduction in the home and status quo biases for risk averse nudged participants.
    Keywords: financial trading, behavioural biases, reminders, nudges, home bias, status quo bias, risk aversion
    JEL: D14 E21 E22 O16
    Date: 2017–09
  17. By: Yves SPRUMONT
    Abstract: Relative Nash welfarism is a solution to the problem of aggregating von Neumann-Morgenstern preferences over a set of lotteries. It ranks such lotteries according to the product of any collection of 0-normalized von Neumann-Morgenstern utilities they generate. We show that this criterion is characterized by the Weak Pareto Principle, Anonymity, and Independence of Harmless Expansions: the social ranking of two lotteries is unaffected by the addition of any alternative that every agent deems at least as good as the one she originally found worst. Relative Nash welfarism is more appealing than relative utilitarianism in contexts where the best relevant alternative for an agent is difficult to identify with confidence.
    Keywords: preference aggregation, lotteries, relative utilitarianism, Nash product
    JEL: D63 D71
    Date: 2017
  18. By: Eric BAHEL; Yves SPRUMONT
    Abstract: We model social choices as acts mapping states of nature to (public) outcomes. A social choice function (or SCF) assigns an act to every profile of subjective expected utility preferences over acts. A SCF is strategyproof if no agent ever has an incentive to misrepresent her beliefs about the states of nature or her valuation of the outcomes; it is ex-post efficient if the act selected at any given preference profile picks a Pareto-efficient outcome in every state of nature. We offer a complete characterization of all strategyproof and ex-post efficient SCFs. The chosen act must pick the most preferred outcome of some (possibly different) agent in every state of nature. The set of states in which an agent's top outcome is selected may vary with the reported belief profile; it is the union of all the states assigned to her by a collection of bilaterally dictatorial and bilaterally consensual assignment rules.
    Keywords: ocial choice under uncertainty, strategyproofness, subjective expected utility, dictatorship, consensuality, bilaterality
    JEL: D71
    Date: 2017
  19. By: Jean Baccelli (THEMA - Théorie économique, modélisation et applications - Université de Cergy Pontoise - CNRS - Centre National de la Recherche Scientifique, IHPST - Institut d'Histoire et de Philosophie des Sciences et des Techniques - UP1 - Université Panthéon-Sorbonne - ENS Paris - École normale supérieure - Paris - CNRS - Centre National de la Recherche Scientifique)
    Abstract: Cette note épistémologique porte sur le statut, en théorie de la décision, des concepts d'attitude par rapport au risque. À première vue, l'analyse axiomatique ne les exploite pas, ce qui reflète une certaine neutralité des modèles de décision au sujet de l'attitude par rapport au risque. Mais un examen plus poussé met en valeur la variation conditionnelle et le renforcement de l'attitude par rapport au risque, qui rattachent les concepts d'attitude par rapport au risque à l'analyse axiomatique.
    Keywords: utilité non-espérée, paradoxe d'Allais,attitude par rapport au risque, utilité espérée
    Date: 2016
  20. By: Gerardo Infante (UEA - University of East Anglia (Norwich)); Guilhem Lecouteux (Department of Economics, Ecole Polytechnique - Polytechnique - X - CNRS - Centre National de la Recherche Scientifique); Robert Sugden (UEA - University of East Anglia (Norwich))
    Abstract: Neoclassical economics assumes that individuals have stable and context-independent preferences, and uses preference satisfaction as a normative criterion. By calling this assumption into question, behavioural findings cause fundamental problems for normative economics. A common response to these problems is to treat deviations from conventional rational choice theory as mistakes, and to try to reconstruct the preferences that individuals would have acted on, had they reasoned correctly. We argue that this preference purification approach implicitly uses a dualistic model of the human being, in which an inner rational agent is trapped in an outer psychological shell. This model is psychologically and philosophically problematic.
    Keywords: context-dependent preferences, behavioural welfare economics, libertarian paternalism,preference purification, inner rational agent
    Date: 2016
  21. By: Yuichi Kitamura; J\"org Stoye
    Abstract: This paper develops and implements a nonparametric test of Random Utility Models. The motivating application is to test the null hypothesis that a sample of cross-sectional demand distributions was generated by a population of rational consumers. We test a necessary and sufficient condition for this that does not rely on any restriction on unobserved heterogeneity or the number of goods. We also propose and implement a control function approach to account for endogenous expenditure. An econometric result of independent interest is a test for linear inequality constraints when these are represented as the vertices of a polyhedron rather than its faces. An empirical application to the U.K. Household Expenditure Survey illustrates computational feasibility of the method in demand problems with 5 goods.
    Date: 2016–06

General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.