nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2017‒12‒11
nineteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Subjective beliefs and decision making under uncertainty in the field By Agarwal, Sandip Kumar
  2. Multinomial logit processes and preference discovery: inside and outside the black box By S. Cerreia-Vioglio; F. Maccheroni; M. Marinacci; A. Rustichini
  3. A Pure Hedonic Theory of Utility and Status: Unhappy but Efficient Invidious Comparisons By Courty, Pascal; Engineer, Merwan
  4. Individual and group preferences over risk: Does group size matter? By Andrea Morone; Francesco Nemore; Tiziana Temerario
  5. Preferences and decision support in competitive bidding By Fugger, Nicolas; Gillen, Philippe; Rasch, Alexander; Zeppenfeld, Christopher
  6. Should Portfolio Model Inputs Be Estimated Using One or Two Economic Regimes? By Emmanouil Platanakis; Athanasios Sakkas; Charles Sutcliffe
  7. Retirement Wealth under Fixed Limits: The Optimal Strategy for Exponential Utility By Lena Schutte
  8. Failure of the Becker-Degroot-Marschak Mechanism in Inexperienced Subjects: New Tests of the Game Form Misconception Hypothesis By Bull, Charlie; Courty, Pascal; Doyon, Maurice; Rondeau, Daniel
  9. The Value of Online Scarcity Signals By Courty, Pascal; Ozel, Sinan
  10. Loss Aversion, Upset Preference, and Sports Television Viewing Audience Size By Brad R. Humphreys; Levi Perez
  11. Learning to forecast, risk aversion, and microstructural aspects of financial stability By Biondo, Alessio Emanuele
  12. Land, Housing, Growth and Inequality By Luigi Bonatti
  13. On the Tail Risk Premium in the Oil Market By Reinhard Ellwanger
  14. Vulnerability from trade in Vietnam By Emiliano Magrini; Pierluigi Montalbano; L. Alan Winters
  15. Unilateral and Multilateral Sanctions: A Network Approach By Sumit Joshi; Ahmed Saber Mahmud
  16. Intergenerational retrospective viewpoints and individual prefe ences of policies for future: A deliberative experiment for forest management By Yoshinori Nakagawa; Koji Kotani; Mika Matsumoto; Tatsuyoshi Saijo
  17. Choice on the simplex domain By Bossert, Walter; Peters, Hans
  18. Three essays on commodity markets By Li, Ziran
  19. Get the Balance Right: A Simultaneous Equation Model to Analyze Growth, Profitability, and Safety By Eling, Martin; Jia, Ruo; Schaper, Philipp

  1. By: Agarwal, Sandip Kumar
    Abstract: Nutrient management decision under uncertainty is a critical and complex decision that a farmer has to make on his field. It is complex as it is a decision that may be linked to several other decisions on their field.Research studies have shown that nutrient application alters the crop yield density. This indicates that nutrient is not limited to be a productive input, but it can also be used as a tool for risk management under uncertainty in agriculture.Researchers have developed models of decision making under uncertainty in agriculture and elsewhere, where strong restrictions on the decision making agents' perception and preferences has been imposed to identify the underlying decision process. Similar, framework has been used for studying the farmer's nutrient decision (mostly based on expected utility or expected profit maximization framework). In the process of modeling the nutrient decision, farmer's perception (expectations) about the nitrogen uncertainty is artificially constructed, which is assumed by researchers to be rational expectations. It is important to note that the choice of optimal nitrogen in a field is a subjective concept, which rests upon the truth and validity of the assumptions introduced in the decision making framework.This dissertation relaxes those arbitrary assumptions about the nitrogen uncertainty by measuring the subjective uncertainty perceived by a farmer surrounding the chosen level of nitrogen. Although, the uncertainty around the chosen level of nitrogen is measured, nothing much can be said about the choice of optimal nitrogen. The subjective expectations of farmer around the optimal level of nitrogen are measured and juxtaposed with the agronomic benchmark. This dissertation is a contribution to the field by providing factual evidence about the discordance between the subjective beliefs of farmers to objective reality. More broadly, this research is an effort towards advancement of the study of agriculture decision making under uncertainty by measurement of subjective expectations of farmer in context to nitrogen yield mapping, which when combined with risk preferences of farmer may be able to identify the true underlying nitrogen decision model for a farmer.
    Date: 2017–01–01
  2. By: S. Cerreia-Vioglio; F. Maccheroni; M. Marinacci; A. Rustichini
    Abstract: We provide both an axiomatic and a neuropsychological characterization of the dependence of choice probabilities on time in the softmax (or Multinomial Logit Process) form where pt (a;A) is the probability that alternative a is selected from the set A of feasible alternatives if t is the time available to decide, u is a utility function on the set of all alternatives, and is an accuracy parameter on a set of time points. MLP is the most widely used model of preference discovery in all elds of decision making, from Quantal Response Equilibria to Discrete Choice Analysis, from Psychophysics and Neuroscience to Combinatorial Optimization. Our axiomatic characterization of soft-max permits to empirically test its descriptive validity and to better understand its conceptual underpinnings as a theory of agents rationality. Our neuropsychological foundation provides a computational model that may explain softmax emergence in human multi-alternative choice behavior and that naturally extends the dominant binary choice Drift Diffusion Model paradigm. Keywords: Discrete Choice Analysis, Drift Diffusion Model, Luce Model, Metropolis Algorithm, Multinomial Logit Model, Quantal Response Equilibrium
    Date: 2017
  3. By: Courty, Pascal; Engineer, Merwan
    Abstract: We examine status preferences where agents compare their own utility relative to the utilities of others, in addition to valuing own consumption. The utility functions are, therefore, implicit functions of each other. As long as status utility comparisons are not too intense, they do not affect either the competitive equilibrium or the set of efficient allocations. However, status utility comparison may substantially reduce average utility and dramatically increase utility inequality. Equating utility with happiness operationalizes the theory and provides an explanation to the puzzle of why invidious comparisons can generate so much unhappiness without much inefficiency. Our theory has very different welfare and political economy implications from other status theories, even when reduced form representations appear observationally equivalent.
    Keywords: Conspicuous consumption; Happiness; inequality; rat race; reference group; Status; utility; welfare
    JEL: D10
    Date: 2017–12
  4. By: Andrea Morone; Francesco Nemore; Tiziana Temerario
    Abstract: In this paper we investigated group size impact on risk aversion when a majority rule is applied. Drawing on the widely used Holt and Laury’s (2002) lottery pairs, we observed a risky shift for both individual and groups regardless of their size. However, groups choices are shown to be closer to the risk-neutrality prediction. More interestingly, whereas smaller groups attitudes can be safely approximated by individual choices, larger groups reveal a statistically different risk-loving attitude. This risky shift becomes more prominent as group size increases.
    Keywords: Preferences; Group; Risk Attitude; Majority Rule; Laboratory.
    JEL: C91 C92 D01
    Date: 2017–11–12
  5. By: Fugger, Nicolas; Gillen, Philippe; Rasch, Alexander; Zeppenfeld, Christopher
    Abstract: We examine bidding behavior in first-price sealed-bid and Dutch auctions, which are strategically equivalent under standard preferences. We investigate whether the empirical breakdown of this equivalence is due to (non-standard) preferences or due to the different complexity of the two formats (i.e., a different level of mathematical/ individual sophistication needed to derive the optimal bidding strategy). We first elicit measures of individual preferences and then manipulate the degree of complexity by offering various levels of decision support. Our results show that the equivalence of the two auction formats only breaks down in the absence of decision support. This indicates that the empirical breakdown is caused by differing complexity between the two formats rather than non-standard preferences.
    Keywords: Auctions,Decision support system,Experiment,Loss aversion,Preferences
    JEL: D44 D81
    Date: 2017
  6. By: Emmanouil Platanakis (School of Management, University of Bath); Athanasios Sakkas (Southampton Business School, University of Southampton); Charles Sutcliffe (ICMA Centre, Henley Business School, University of Reading)
    Abstract: Estimation errors in the inputs are the main problem when applying portfolio analysis. Markov regime switching models are used to reduce these errors, but they do not always improve out-of-sample portfolio performance. We investigate the levels of transaction costs and risk aversion below which the use of two regimes is superior to one regime for an investor with a CRRA utility function, allowing for skewed and kurtic returns. Our results suggest that, due to differences in risk and transactions costs, most retail investors should use one regime models, while investment banks should use two regime models.
    Keywords: finance, portfolio theory, regime shifting, transaction costs, risk aversion, constant relative risk aversion
    JEL: G11
    Date: 2017–09
  7. By: Lena Schutte
    Abstract: For an exponential utility maximizing investment strategy in a Black-Scholes Setting, fixed upper and lower constraints are introduced on the terminal wealth. This is equivalent to combining the optimal strategy with options. The resulting distribution is investigated in terms of change of quantiles. The theory is illustrated with quantitative examples, including an assessment of the effects of restricting the strategy to positive investments.
    Date: 2017–12
  8. By: Bull, Charlie; Courty, Pascal; Doyon, Maurice; Rondeau, Daniel
    Abstract: Substantial efforts have been devoted to understanding deviations from optimal behavior in games. Cason and Plott (2014, hereafter CP) propose that sub-optimal behavior may be explained by game form misconception (GFM), a failure of game form recognition, rather than by non-standard preferences or framing effects. Following CP's application of the GFM theory to the Becker-DeGroot-Marschak mechanism (Becker et al., 1964, hereafter BDM), this paper explores whether GFM can robustly explain bidding mistakes by inexperienced subjects. We derive two new tests of the GFM hypothesis based on comparing subject behavior in the misconceived task (BDM) and on the task it is misconceived for (a first price auction). While we do replicate Cason and Plot's original results, our additional tests are inconsistent with a first price misconception explaining observed deviations from optimal bidding in the BDM. At a minimum, additional forms of misconception are necessary to explain observed bidding behavior.
    Keywords: Becker-DeGroot-Marschak; game form misconception; Game form recognition; mistake; preference elicitation.
    JEL: C8 C9
    Date: 2017–12
  9. By: Courty, Pascal; Ozel, Sinan
    Abstract: Online retailers use scarcity cues to increase sales. Many fear that these pressure tactics are meant to manipulate behavioral biases by creating a sense of urgency. At the same time, scarcity cues could also convey valuable information. We measure the value of the scarcity messages posted by Expedia to a Bayesian rational consumer. A signal reveals information on the number of seats available at the posted price. Consumers can use this information to optimally time when they purchase a ticket. The maximum increase in expected utility for a naive consumer, who does not use publicly available information, is 8 percent. For a sophisticated consumer, the increase is between 4-7 percent. Scarcity signals have a negligible impact on seller revenue and consumption.
    Keywords: Airline Ticket.; Online Recommendations; Persuasion; price discrimination; Scarcity
    JEL: L1
    Date: 2017–12
  10. By: Brad R. Humphreys (West Virginia University, Department of Economics); Levi Perez (University of Oviedo, Department of Economics)
    Abstract: A growing body of research examines the effect of loss aversion (LA) on consumers’ decisions to watch or attend sporting events. Much of this research focuses on live game attendance. In contrast to the predictions of uncertainty of outcome hypothesis (UOH), loss-averse consumers prefer watching either potential upsets, or dominant performances by strong favorites, to events with uncertain outcomes. We test for LA vs. UOH effects in television viewing audience data for free over-the-air broadcasts of 304 Spanish football matches from 2008/09 to 2015/16. This setting generates substantial variation home team win probabilities because of the presence of Real Madrid CF and FC Barcelona. The results support the importance of LA/upset preferences: audience size for matches when home teams are large underdogs and when heavily favored are larger than for matches with uncertain outcomes, even when controlling for observable and unobservable factors affecting the number of viewers.
    Keywords: loss aversion, upset preference, consumer decisions, television audience, football
    JEL: L82 L15
    Date: 2017–11
  11. By: Biondo, Alessio Emanuele
    Abstract: This paper presents a simulative model of a financial market, based on a fully operating order book with limit and market orders. The heterogeneity of traders is characterized not only with regards to their trading rules, but also by introducing a behavioral individual risk aversion and a learning ability influencing the process of expectations formation. Results show that individual learning may play a role in stabilizing the aggregate market dynamics, whereas risk aversion can, counterintuitively, have perverse consequences on it.
    Keywords: order book,learning to Forecast,risk aversion,agent based models
    JEL: E44 E47 C63
    Date: 2017
  12. By: Luigi Bonatti
    Abstract: This paper contains a growth model that incorporates productive assets, residential land and residential structures. Moreover, it accounts for the existence of two social classes: the capitalists, who invest both in productive assets and in housing but do not provide labor services, and the workers, who invest only in housing and decide on how much labor effort to provide. Within this formal setup, it is shown that the relative price of land grows in the long run at the same rate as the economy’s GDP, while both the quantity of housing services and their price grow slower than it. Numerical examples show that i) shifting the taxation away from income and towards the property of land enhances long-term GDP growth and leads in the long-run to a more equalitarian (i.e. more favorable to the workers) income and wealth distribution, ii) a marginal increase in the fraction of investment expenditures in residential structures that is tax deductible reduces inequality in the distribution of income and wealth, iii) a change in agents’ preferences that gives more weight in the utility function to residential services leads in the long run to a distribution of income and wealth that is more favorable to the capitalists, iv) changes in taxation or in preferences increasing the fraction of total investment devoted to the accumulation of residential wealth rather than to the accumulation of productive assets brings about a balanced growth path characterized by a higher wealth-income ratio. Moreover, the paper illustrates how endogenous fluctuations may be generated along the equilibrium trajectory converging to the balanced growth path, in a model where housing wealth—as well as residential land—is distinguished from productive capital and only fundamentals (initial endowments, preferences and technologies) drive the economy’s dynamics.
    Keywords: Productive assets, Residential structures, Urban rents, Land value tax
    JEL: H24 O18 O41 R31
    Date: 2017
  13. By: Reinhard Ellwanger
    Abstract: This paper shows that changes in market participants’ fear of rare events implied by crude oil options contribute to oil price volatility and oil return predictability. Using 25 years of historical data, we document economically large tail risk premia that vary substantially over time and significantly forecast crude oil futures and spot returns. Oil futures prices increase (decrease) in the presence of upside (downside) fears in order to allow for smaller (larger) returns thereafter. This increase (decrease) is amplified for the spot price because of time varying-benefits from holding physical oil inventories that work in the same direction. We also provide support for view that that time variation in the relative importance of oil demand and supply shocks is an important determinant of oil price fluctuations and their interaction with aggregate outcomes. However, the option-implied tail risk premia are not spanned by traditional macroeconomic and oil market uncertainty measures, suggesting that time-varying oil price fears are an additional source of oil price volatility and predictability.
    Keywords: Asset Pricing, Econometric and statistical methods, Financial markets
    JEL: C53 C58 D84 E44 G12 G13 Q43
    Date: 2017
  14. By: Emiliano Magrini (Food and Agriculture Organization, Rome); Pierluigi Montalbano (Department of Economics, University of Sussex; Department of Economics and Social Sciences, Sapienza University of Rome); L. Alan Winters (Department of Economics, University of Sussex)
    Abstract: This paper assesses vulnerability from trade in Vietnam by presenting an extended version of Ligon and Schechter’s (2003) Vulnerability as low Expected Utility (VEU) measure. It uses the VHLSS panel data covering the period 2002-06. The empirical results show that risk-induced vulnerability and heterogeneity in trade exposure matters in determining household overall vulnerability and that this is not linked to the actual manifestation of shocks. Although it does not represent, by any means, an argument against free trade, this work is relevant for policymaking since it contributes to deepen our knowledge on the subtle links between trade openness and vulnerability providing some insight on the stabilisation needs of trade reforms. These include protecting vulnerable farmers from excessive price volatility, as well as fostering their risk management strategies.
    Keywords: trade openness; vulnerability; poverty; risk; consumption behaviour; Vietnam
    JEL: F14 O12 D12 C31
    Date: 2017–11
  15. By: Sumit Joshi (George Washington University); Ahmed Saber Mahmud (Johns Hopkins University)
    Abstract: The extensive literature on efficacy of sanctions has been mainly focused on a dyadic inter- action between sender and target. In contrast, this paper examines sanctions when the sender and target are embedded in a network of linkages to other agents and each agent’s utility is a function of the size of the agent’s component. Efficacy of sanctions is then a function of two factors: the network structure binding the sender and target, and the con- cavity/convexity of utility in the component size. We consider both unilateral sanctions and multilateral sanctions. We demonstrate how the network architecture, together with the specification of utility, qualifies and sometimes reverses the main tenets of the dyadic approach. We add to the recent work on identifying network architectures that sustain cooperation via the threat of exclusion by showing that the utility specification matters. Thus the same network can be efficacious for sanctions if utility is convex in component size but not if it is concave.
    Keywords: Unilateral sanctions, Multilateral sanctions, Sender, Target, Networks, Spanning trees, Cutsets
    JEL: C72 D74 D85
    Date: 2017
  16. By: Yoshinori Nakagawa (Research Center for Future Design, Kochi University of Technology); Koji Kotani (Research Center for Future Design, Kochi University of Technology); Mika Matsumoto (Research Center for Future Design, Kochi University of Technology); Tatsuyoshi Saijo (Research Center for Future Design, Kochi University of Technology)
    Abstract: Brain scientists establish that projecting future events can influence how human brains function and possibly current decisions (Schultz et al., 1997, Gilbert and Wilson, 2007, Gerlach et al., 2014, Szpunara et al., 2014). We design and institute a deliberative experiment to test whether acquisition and experience of intergenerational retrospective viewpoints as one way of projecting future events affect individual preferences for policies. To this end, we employ a case-method approach for forest management policies in Kochi prefecture, Japan, because the problems extend over multiple generations in nature. We prepare two treatments of non-retrospective and retrospective settings where subjects are asked to read through a case of forest management and to reveal preferences for policies at individual and group levels through deliberative discussions. Subjects in the retrospective treatment go through a series of procedures to acquire intergenerational retrospective viewpoints, while those in the non-retrospective treatment do not. The results reveal that acquisition and experience of intergenerational retrospective viewpoints affect individual preferences for forest policies in the sense that the most favorite policies chosen by subjects in the retrospective treatment are different from those in the non-retrospective treatment. Subjects in the retrospective treatment have tendencies to choose the policies as the most favorite that fundamentally change status-quo, while those in the non-retrospective treatment are opposite. Overall, this result suggests that some education or training for acquiring intergenerational retrospective viewpoints as part of projecting future could possibly affect the ways of thinking and preferences for possible betterment of the future.
    Keywords: intergenerational retrospective viewpoint, preferences of policies
    Date: 2017–11
  17. By: Bossert, Walter (centre interuniversitaire de recherche en economie quantitative (cireq)); Peters, Hans (QE / Mathematical economics and game the)
    Abstract: One unit of a good has to be divided among a group N of individuals who each are entitled to a minimal share and these shares sum up to less than one. The associated set of choice problems consists of the unit simplex and all its full-dimensional subsimplices with the same orientation. We characterize all choice rules that are independent of irrelevant alternatives, continuous, and monotonic. The resulting rules are what we refer to as N-path choice functions. If there are only three individuals, the monotonicity property can be weakened. We also consider the issue of rationalizability and show that, for the threeagent case, excluding cycles of length three in the revealed preference relation implies the strong axiom of revealed preference, that is, the exclusion of cycles of any length.
    Keywords: choice functions, simplex domain, rationalizability
    JEL: D11 D71
    Date: 2017–12–05
  18. By: Li, Ziran
    Abstract: The three essays that constitute this dissertation aim to understand the role of agribusiness organizational structures in competition, the risk management practices of grain producers, and the characteristics of the U.S. corn harvest futures price.The cooperative (co-op) model is held up as a novel solution to many kinds of market failures. It integrates the business successes and members’ utilities and provides a countervailing force to the market power of investor-owned firms (IOFs). A traditional cooperative business is characterized as being owned and controlled by its member-users, to whom benefits are intended to primarily accrue. The user-benefit principle has given rise to diverse assumptions regarding the objectives of co-ops in the existing literature. And the theoretical literature has yet to reconcile the extent to which operating objectives of a cooperative business deviate from profit maximization. Chapter 2 adds to the literature by developing a model of duopsony competition from which the strategic interactions of a cooperative firm and an investor owned firm (IOF) under output price uncertainty are interpreted. I analyze the way in which the market equilibrium varies as the co-op takes on different objectives.Crop producers’ risk management practices have long been understood using either survey based data or aggregate trading data. These studies suggest there is limited relevance of Expected Utility (EU) optimal hedging theory as farmers may deviate from rationality. There are two impediments to this line of research. First, hedging theories that rely on alternative utility paradigms may be too complicated to test with data. Second, there is a lack of data on the actual hedging activities of producers. Chapter 3 provides a solution that partially overcomes these two problems. I investigate the role of reference-dependence, a central feature of most utility paradigms other than EU in the optimal hedging theory under the EU framework. The theoretical predictions facilitate a direct comparison of optimal hedge ratios with and without a reference price. I then test the model’s results with a unique database of forward contracting transactions of Iowa corn producers over a five-year period. The corn producers’ hedging pattern indeed appears to be reference-dependent: more hedges are placed when futures prices rise above the recent price trend. This finding has important implications for future research on grain producers’ marketing practices because if the futures markets are efficient, price-based triggers as a motivation for hedging may not be beneficial to farm income.A well-known phenomenon in the corn futures market, weather premium, suggests that producers may enhance their marketing strategies by forward contracting early in the season. This is because the commodity futures market for grain over-predicts the actual harvest price more often than not. Chapter 4 formally defines the weather premium, and recovers the potential weather premium in the corn futures market. I show theoretically that the size of weather premium depends on the expected supply at harvest, which consists of the carryout from last year and the expected new harvest. These two covariates partially explain the variation of the forecast error of the December futures contract price from 1968 to 2015. However, the existence of weather premium does not imply the biasness in the futures, i.e. risk premium. The Sharpe ratio of the passive strategy of routinely shorting the corn December futures in spring is too small to justify such an approach.
    Date: 2017–01–01
  19. By: Eling, Martin; Jia, Ruo; Schaper, Philipp
    Abstract: Extant literature suggests that the relationships among growth, profitability, and safety are reciprocal. Consequently, we develop a simultaneous equation model to test the three relationship pairs. Analyzing eleven years of data for 1,988 European insurance companies, we find that moderate firm growth has a positive impact on profitability; however, extremely high growth reduces profitability. Moderate firm growth also reduces firm risk. In addition, we document that less profitable companies are risk-seeking, a result in line with prospect theory. The longitudinal analysis illustrates that firms initially prioritizing profitability over growth are more likely to reach the ideal state of “profitable growth”.
    Keywords: firm performance, simultaneous equation model, goal conflicts, financial services, insurance
    Date: 2017–10

This nep-upt issue is ©2017 by Alexander Harin. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
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.