nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2017‒10‒29
eighteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Risk Aversion as a Perceptual Bias By Mel Win Khaw; Ziang Li; Michael Woodford
  2. Everything all the time? Entry and Exit in U.S. Import Varieties By Miklós Koren; Roc Armenter
  3. English versus Vickrey Auctions with Loss Averse Bidders By von Wangenheim, Jonas
  4. Should Pollution Taxes be Targeted at Income Redistribution? By Bas Jacobs; Rick van der Ploeg
  5. News, Uncertainty and Economic Fluctuations (No News is Good News) By Mario Forni; Luca Gambetti; Luca Sala
  6. Sticky Belief Adjustment: A Double Hurdle Model and Experimental Evidence By Timo Henckel; Gordon Menzies; Peter Moffat; Daniel J. Zizzo
  7. Environmental Tax Reform and Income Distribution with Imperfect Heterogeneous Labour Markets By Diane Aubert; Mireille Chiroleu-Assouline
  8. Understanding the Impact of Tuition Fees in Foreign Education: the Case of the UK. By Lionel Ragot; Michel Beine; Marco Delogu
  9. Countercyclical Endogenous Uncertainty Shocks, Efficiency Wages and Procyclical Precautionary Labor Productivity By Jean-Michel Grandmont
  10. Dynamic Portfolio Optimization with Looping Contagion Risk By Longjie Jia; Martijn Pistorius; Harry Zheng
  11. Referential Revealed Preference Theory By Hassan Nosratabadi
  12. Reported Preference vs. Revealed Preference: Evidence from the Propensity to Spend Tax Rebates By Jonathan A. Parker; Nicholas S. Souleles
  13. Uninformed buyers and market efficiency By Maier, Carl G.; Marencak, Michal
  14. Rational Filters By Hassan Nosratabadi
  15. Models for individual adoption of eCommerce, eBanking and eGovernment in Spain By Garín-Muñoz, Teresa; López, Rafael; Pérez-Amaral, Teodosio; Herguera García, Iñigo; Valarezo, Angel
  16. Reforming Medicaid Long Term Care Insurance By Minchung Hsu; Gary Hansen; Elena Capatina
  17. A Monte Carlo Evaluation of the Logit-Mixed Logit under Asymmetry and Multimodality By Riccardo Scarpan; Cristiano Franceschinis; Mara Thiene
  18. Prospect Theory and Earnings Manipulation: Examination of the Non-Uniform Relationship between Earnings Manipulation and Stock Returns Using Quantile Regression By Leon Li; Nen-Chen Richard Hwang

  1. By: Mel Win Khaw; Ziang Li; Michael Woodford
    Abstract: The theory of expected utility maximization (EUM) proposed by Bernoulli explains risk aversion as a consequence of 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 D80 D81 D87
    Date: 2017
  2. By: Miklós Koren (Central European University); Roc Armenter (Federal Reserve Bank of Philadelphia)
    Abstract: We propose a new theory of the extensive margin of trade based on a standard random-utility, discrete choice model for import demand. Crucially, there are only a finite number of independent purchase decisions each period. Whereas traditional demand systems predict market shares, our model yields instead the probability that a purchase for a given good is supplied by any given country. The model has a rich set of predictions regarding the extensive margin across goods, countries, and time. The model naturally reconciles two commanding observations in the data: there is a large fraction of varieties that are not traded yet the entry and exit rates of commodities are very high. We purse an exhaustive evaluation of the model's quantitative performance with data on U.S. imports at the HS10 product level over the period 1990-2001. The model reproduces faithfully the cross-section distribution of varieties traded per product along several dimensions. Regarding dynamic facts, the model is spot on with its predictions on the net change, gross entry and exit of commodities, both by count and weighted by value; as well as survival probabilities and hazard rates. We briefly explore the model's implications for price changes, using NAFTA as a case study, and welfare gains from new varieties.
    Date: 2017
  3. By: von Wangenheim, Jonas (Humboldt University Berlin)
    Abstract: Evidence suggests that people evaluate outcomes relative to expectations. I analyze this expectation-based loss aversion (Köszegi and Rabin (2006, 2009)) in the context of dynamic and static auctions, where the reference point is given by the (endogenous) equilibrium outcome. If agents update their reference point during the auction, the arrival of information crucially affects equilibrium behavior. Consequently, I show that even with independent private values the Vickrey auction yields strictly higher revenue than the English auction, violating the well known revenue equivalence. Thus, dynamic loss aversion offers a novel explanation for empirically observed differences between these auction formats.
    Keywords: vickrey auction; english auction; expectation-based loss aversion; revenue equivalence; dynamic loss aversion; personal equilibrium;
    JEL: D03 D44
    Date: 2017–10–20
  4. By: Bas Jacobs; Rick van der Ploeg
    Abstract: This paper analyses optimal corrective taxation and optimal income redistribution. Under general utility functions, the Pigouvian pollution tax is higher if pollution damages disproportionally hurt the poor due to equity weighting of pollution damages. Moreover, optimal pollution taxes should be set below the Pigouvian tax if the poor spend a disproportionate fraction of their income on polluting goods. However, if preferences for commodities are of the Gorman (1961) polar form, optimal pollution taxes should follow the first-best rule for the Pigouvian corrective tax even if the government wants to redistribute income and the poor spend a disproportional part of their income on polluting goods. The often-used quasi-linear, CES and Stone-Geary utility functions all belong to the Gorman polar class. If preferences are Gorman polar, and if pollution taxes are not optimized, Pareto-improving green tax reforms exist that move the pollution tax closer to the Pigouvian tax. Simulations demonstrate that optimal corrective taxes should be Pigouvian if the demand for polluting goods is derived from a LES demand system, but deviate from the Pigouvian taxes if demand for polluting goods demand is derived from a PIGLOG demand system.
    Keywords: redistributive taxation, corrective pollution taxation, Gorman polar form, Stone-Geary preferences, PIGLOG preferences, green tax reform
    JEL: H21 H23 Q54
    Date: 2017
  5. By: Mario Forni; Luca Gambetti; Luca Sala
    Abstract: We formalize the idea that uncertainty is generated by news about future developments in economic conditions which are not perfectly predictable by the agents. Using a simple model of limited information, we show that uncertainty shocks can be obtained as the square of news shocks. We develop a two-step econometric procedure to estimate the effects of news and we find highly nonlinear e ects. Large news shocks increase uncertainty. This mitigates the effects of good news and amplifies the effects of bad news in the short run. By contrast, small news shocks reduce uncertainty and increase output in the short run. The Volcker recession and the Great Recession were exacerbated by the uncertainty effects of news.
    Keywords: news shocks, uncertainty shocks, imperfect information, structural VARs
    JEL: C32 E32
    Date: 2017–10
  6. By: Timo Henckel (Australian National University); Gordon Menzies (Economics Discipline Group, University of Technology, Sydney); Peter Moffat (School of Economics, University of East Anglia); Daniel J. Zizzo (Newcastle University Business School)
    Abstract: Given a lack of perfect knowledge about the future, agents need to form expectations about variables affecting their decisions. We present an experiment where subjects sequentially receive signals about the true state of the world and need to form beliefs about which one is true, with payoffs related to reported beliefs. We control for risk aversion using the Offerman et al. (2009) technique. Against the baseline of Bayesian updating, we test for belief adjustment under-reaction and over-reaction and model the decision making process of the agent as a double hurdle model where agents first decide whether to adjust their beliefs and, if so, then decide by how much. We find evidence for sticky belief adjustment. This is due to a combination of: random belief adjustment; state-dependent belief adjustment, with many subjects requiring considerable evidence to change their beliefs; and Quasi-Bayesian belief adjustment, with insufficient belief adjustment when a belief change does occur.
    Keywords: belief revision; double hurdle model; expectations; overreaction; underreaction
    JEL: C34 C91 D03 D84
    Date: 2017–04–07
  7. By: Diane Aubert; Mireille Chiroleu-Assouline
    Abstract: This paper investigates the distributional and efficiency consequences of an environmental tax reform, when the revenue from the green tax is recycled by varying labor tax rates. We build a general equilibrium model with imperfect heterogeneous labor markets, pollution consumption externalities, and non-homothetic preferences (Stone-Geary utility). We show that in the case where the reform appears to be regressive, the gains from the double dividend can be made Pareto improving by using a redistributive non-linear income tax if redistribution is initially not too large. Moreover, the increase of progressivity acts on unemployment and can moderate the trade-off between equity and efficiency. We finally provide numerical illustrations for three European countries featuring different labor market behaviors. We show that a double dividend may be obtained without worsening the initial inequalities if the green tax revenues are redistributed with a progressivity index lower for UK than for France and Germany.
    Keywords: environmental tax reform, heterogeneity, unemployment, welfare analysis, tax progressivity
    JEL: D62 D63 H23 Q52 Q58
    Date: 2017
  8. By: Lionel Ragot; Michel Beine; Marco Delogu
    Abstract: This paper studies the determinants of international students mobility at the university level, focusing specifically on the role of tuition fees. We first develop an original Random Utility Maximization model of location choice for international students in the presence of capacity constraints of the hosting institutions. The last layer of the model gives rise to a gravity equation. This equation is estimated using new data on student migration flows at the university level for the U.K. We control for the endogeneity of tuition fees by taking benefit of the institutional constraints in terms of tuition caps applied in the UK to European students at the bachelor level. The estimations support a negative impact of tuition fees and stress the need to account for the endogenous nature of the fees in the empirical identification of their impact. The estimations also support an important role of additional destination-specific variables such as host capacity, the expected return of education and the cost of living in the vicinity of the university.
    Keywords: Foreign students; Tuition fees; Location choice; University Quality.
    JEL: F22 H52 I23 O15
    Date: 2017
  9. By: Jean-Michel Grandmont (Department of Economics, University Of Venice Cà Foscari; CREST (EXCESS, UMR CNRS 9194), University of Paris-Saclay, France; and RIEB Fellow, University of Kobe, Japan)
    Abstract: This work introduces a new mechanism generating procyclical comovements of labor productivity, employment, through endogenous variations of workers’ effort, in a simple model with efficiency wages, near a locally indeterminate steady state. A current endogenous countercyclical uncertainty shock makes risk averse workers more willing to provide imperfectly monitored “precautionary effort” by increasing their expected utility gain of not shirking. If workers’ relative prudence is small and decreasing fast near the steady state, firms’ efficiency wage contracts generate significant endogenous procyclical variations of effort, employment and labor productivity, in particular when the capital-efficient labor elasticity of substitution is smaller than and close to 1.
    Keywords: Efficiency wages, unemployment, expectation driven business cycles, conditionally heteroskedastic sunspots, countercyclical uncertainty shocks, prudence, procyclical labor effort and productivity
    JEL: D81 D84 E10 E24 E32 J30 J41
  10. By: Longjie Jia; Martijn Pistorius; Harry Zheng
    Abstract: In this paper we consider a utility maximization problem with defaultable stocks and looping contagion risk. We assume that the default intensity of one company depends on the stock prices of itself and another company, and the default of the company induces an immediate drop in the stock price of the surviving company. We prove the value function is the unique continuous viscosity solution of the HJB equation. We also compare and analyse the statistical distributions of terminal wealth of log utility based on two optimal strategies, one using the full information of intensity process, the other a proxy constant intensity process. These two strategies may be considered respectively the active and passive optimal portfolio investment. Our simulation results show that, statistically, active portfolio investment is more volatile and performs either much better or much worse than the passive portfolio investment in extreme scenarios.
    Date: 2017–10
  11. By: Hassan Nosratabadi (Rutgers, The State University Of New Jersey)
    Abstract: References can influence choice. One of the well-studied cases is when a decoy is added to the menu. However small in magnitude, decoy effect violates the weak axiom of revealed preferences (WARP). In order to explain the small deviation from the classical revealed preference theory, I decompose WARP into independent axioms in order to only remove the ones which are inconsistent with the this effect. This minimal deviation produces the referential revealed preference theory that keeps the strong predictive power offered in the classical theory while explaining the referential effect.
    Keywords: Reference-Dependent Choice, Reference Preferences, Decoy Effect, Attraction Effect, WARP Decomposition
    JEL: D11 D81
    Date: 2017–10–20
  12. By: Jonathan A. Parker; Nicholas S. Souleles
    Abstract: We evaluate the consistency of two methods for estimating the effect of an economic policy: i) surveying people to report the change in their behavior caused by the policy, ii) inferring this change using (reported) actual behavior and differences in treatment across people. Both methods have been widely used to measure propensities to spend. Using Federal stimulus payments disbursed quasi-randomly over time in 2008, we find greater revealed-preference estimates of spending by households reporting greater spending and the two methods produce similar estimates of average spending. But, counterfactually, reported-preferences estimates are not higher for households with lower liquidity.
    JEL: B40 C42 D14 E21 E62 H31
    Date: 2017–10
  13. By: Maier, Carl G.; Marencak, Michal
    Abstract: Empirical evidence shows that low cost of signaling interest in offers can result in a significant number of inappropriate signals. This paper provides a theoretical explanation for this observation as an equilibrium outcome of a model with utility maximizing fully rational agents that decide to signal their interest without knowing whether the offer suits them or not. We show that falling transaction costs can decrease market efficiency and social welfare.
    JEL: C72 D83 E24
    Date: 2017
  14. By: Hassan Nosratabadi (Rutgers, The State University Of New Jersey)
    Abstract: It has been widely documented that reference points influence the choice. If references affect choice by attracting attention towards an alternative, what can be said about the joint effect of the references? Assuming that references form preferences, or are rational filters, this paper extracts a reference-dependent choice model with joint referential effects from WARP. Assume that a DM has an ''unfiltered'' pairwise preference which is inferred from her choice over doubletons. The DM's uses her rational filters consecutively on the pairwise preference in order to finalize her choice.
    Keywords: Rational Preferences, Rational Filters, Revealed Preference, Referential Decision Maker, WARP Decompositions
    JEL: D11 D81
    Date: 2017–10–20
  15. By: Garín-Muñoz, Teresa; López, Rafael; Pérez-Amaral, Teodosio; Herguera García, Iñigo; Valarezo, Angel
    Abstract: This paper analyzes the adoption patterns of selected internet services such as eCommerce, eBanking and eGovernment in Spain. High quality official data from the Survey on Equipment and Use of Information and Communication Technologies in Households (ICT-H) of the National Institute of Statistics are used. The dataset is a cross section of 16,209 individuals for 2016. Theoretical demand models, grounded in a standard neoclassical utility maximization framework, are adapted to these services. Logistic regression techniques allow quantifying the impact of the socioeconomic characteristics of the individual on the adoption of each service. The resulting models are statistically significant and with a high predictive power. Age, education and levels of internet and computer skills are all significant in explaining the adoption of any of the three services; as are gender and income, but just for eCommerce and eBanking. Interestingly, the level of trust in internet is only significant to explain participation in eCommerce. Finally, policy recommendations are suggested, highlighting the desirability of using specific measures for the different socio-demographic groups and income strata.
    Keywords: ECommerce,eBanking,eGovernment,logistic model,digital divide
    Date: 2017
  16. By: Minchung Hsu (National Graduate Institute for Policy Studies); Gary Hansen (UCLA); Elena Capatina (UNSW Business School)
    Abstract: We build a life-cycle model of household consumption and saving decisions, where long term care (LTC) expenditures are endogenous. We use an LTC-state dependent utility function where regular consumption and LTC are valued differently. The model includes both married and single households, thus capturing important family dynamics that are important for precautionary savings and LTC decisions. Married individuals face the risk of a spouse needing LTC and quickly depleting joint assets. However, those needing LTC can benefit from the presence of a healthy spouse who provides informal care, lowering the costs of LTC given a fixed quality of care. We use the calibrated model to estimate the importance of family dynamics for savings and consumption decisions, and also to quantify the impacts of LTC policy reforms such as the provision of a universal public system that pays for a minimum level of LTC costs.
    Date: 2017
  17. By: Riccardo Scarpan (University of Waikato); Cristiano Franceschinis (University of Padova); Mara Thiene (University of Padova)
    Abstract: The recently introduced (Train 2016) logit-mixed logit (LML) model is a key advancement in choice modelling: it generalizes many previous parametric and semi-nonparametric methods to represent taste heterogeneity for bundled nonmarket goods and services. We report results from Monte Carlo experiments designed to assess performance across workable sample sizes and to retrieve data-driven random coefficients distributions in the three variants of the LML model proposed in the seminal paper. Assuming a multi-modal data generating process, with a panel of four and eight choices per respondent, we compare the performance of WTP-space LML models with conventional parametric model specifications based on the Mixed logit model with normals (MXL-N) in preference and WTP space. Results are encouraging and support the adoption of flexible LML specifications with a high number of parameters as they seem to do better, but only at large enough sample sizes. To explore the saliency of the Monte Carlo results in an empirical application, we use data obtained from a discrete choice experiment to derive preferences for tap water quality in the province of Vicenza (northern Italy). LML models retrieve multimodal and asymmetric distributions of marginal WTPs for water quality attributes. Results show not only how the shape of such distributions vary across tap water attributes, but also the importance of being able to uncover them, considering that they would be hidden when using the MNL-N.
    Keywords: logit-mixed logit; flexible taste distributions; panel random utility models
    Date: 2017–10–24
  18. By: Leon Li (University of Waikato); Nen-Chen Richard Hwang (California State University, San Marcos)
    Abstract: Using the prospect theory as a research framework, this paper makes contributions by demonstrating that managerial risk preference and stock return may influence a firm’s earnings manipulation behavior. Specifically, this study argues that corporate executives may develop risk-averting (risk-seeking) attitudes because of high and positive (low and negative) stock returns. Under this scenario, managers may decide to actively manage the reported earnings in order to preserve gain (gamble on loss) on stock returns. On the other hand, firm executives may not actively manipulate their reported incomes when experiencing average and close-to-zero stock returns. Using quantile regression method to examine the relation between earnings manipulation and stock returns, this study finds that there is a significantly positive (negative) relation between earnings manipulation and stock returns at the high (low) stock returns quantiles. As predicated, such relation is not significant at the middle range of stock returns. To ensure the findings reported in this study are robust, we conduct several tests. In conclusion, we offer policy implications to regulators.
    Keywords: prospect theory; quantile regression; earnings manipulation; stock return; discretionary accruals
    JEL: G12 G32
    Date: 2017–10–27

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