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on Utility Models and Prospect Theory |
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Issue of 2018‒01‒22
fifteen papers chosen by |
| By: | Pengyu Zhu |
| Abstract: | Mutually exclusive decisions have been studied for decades. Many well-known decision theories have been defined to help people either to make rational decisions or to interpret people's behaviors, such as expected utility theory, regret theory, prospect theory, and so on. The paper argues that none of these decision theories are designed to provide practical, normative and quantitative approaches for multiple mutually exclusive decisions. Different decision-makers should naturally make different choices for the same decision question, as they have different understandings and feelings on the same possible outcomes.The author tries to capture the different understandings and feelings from different decision-makers, and model them into a quantitative decision evaluation process, which everyone could benefit from. The basic elements in classic expected utility theory are kept in the new decision theory, but the influences from mutually exclusive decisions will also be modeled into the evaluation process. This may sound like regret theory, but the new approach is designed to fit multiple mutually exclusive decision scenarios, and it does not require a definition of probability weighting function. The new theory is designed to be simple and straightforward to use, and the results are expected to be rational for each decision-maker. |
| Date: | 2018–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1801.02422&r=upt |
| By: | Victor H. Aguiar; Roberto Serrano |
| Abstract: | We present a new notion of cardinal revealed preference that exploits the expenditure information in classical consumer theory environments with finite data. We propose a new behavioral axiom, Acyclic Enticement (AE), that requires the acyclicity of the cardinal revealed-preference relation. AE is logically independent from the Weak Axiom of Revealed Preference (WARP). We show that the Generalized Axiom of Revealed Preference (GARP), which characterizes the standard rational consumer, is logically equivalent to AE and WARP. We propose a new notion of rationalization by means of a price-dependent utility function that characterizes AE, which in particular is suitable for welfare analysis. We also propose a consistency condition for preference functions that is equivalent to WARP. We use our axiomatic decomposition to show, in experimental and scanner consumer-panel data sets, that AE explains the majority of the predictive success of GARP. Moreover, AE taken alone is superior in predictive success to both WARP and GARP. |
| Date: | 2018 |
| URL: | http://d.repec.org/n?u=RePEc:bro:econwp:2018-3&r=upt |
| By: | Luo, Yulei; Nie, Jun (Federal Reserve Bank of Kansas City); Wang, Haijun |
| Abstract: | This paper constructs a recursive utility version of a canonical Merton (1971) model with uninsurable labor income and unknown income growth to study how the interaction between two types of uncertainty due to ignorance affects strategic consumption-portfolio rules and precautionary savings. Specifically, after solving the model explicitly, we theoretically and quantitatively explore (i) how these ignorance-induced uncertainties interact with intertemporal substitution, risk aversion, and the correlation between the equity return and labor income, and (ii) how they jointly affect strategic asset allocation, precautionary savings, and the equilibrium asset returns. Furthermore, we use data to test our model’s predictions on the relationship between ignorance and asset allocation and quantitatively show that the interaction between the two types of uncertainty is the key to explain the data. Finally, we find that the welfare costs of ignorance can be very large. |
| Keywords: | Ignorance; Unknown Income Growth; Induced Uncertainty; Strategic Asset Allocation |
| JEL: | C61 D81 E21 |
| Date: | 2017–11–01 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedkrw:rwp17-13&r=upt |
| By: | David Hirshleifer; Chong Huang; Siew Hong Teoh |
| Abstract: | Ambiguity aversion alone does not explain the market nonparticipation puzzle. We show that in a rational expectations equilibrium model with a fund offering the risk-adjusted market portfolio (RAMP), ambiguity averse investors hold the fund and an information-based portfolio, and thus participate in all asset markets, directly or indirectly. This result follows from a new separation theorem which states that an investor’s equilibrium portfolio can be decomposed into components, each matching the optimal portfolio based on only one information source (price versus private signal). Asset risk premia satisfy the CAPM with the fund as the pricing portfolio. |
| JEL: | F3 G11 G12 G14 G15 |
| Date: | 2017–12 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:24143&r=upt |
| By: | Dertwinkel-Kalt, Markus; Wenzel, Tobias |
| Abstract: | This paper develops a theory of focusing and framing in an intertemporal context with risky choices. We provide a selection criterion between existing theories of fo- cusing by allowing a decision maker to choose her frame such that her attention is either drawn to salient events associated with an option or to the expected utilities an option yields in different time periods. Our key assumption is that a decision maker can choose her frame in a self-serving manner. We predict that the selected frame induces overoptimistic actions in the sense that subjects underrate downside risk but overrate upside risk and accordingly reveal overoptimistic choices. Hence, our theory can explain phenomena such as excessive harmful consumption (smoking, unhealthy diet) and risky investments (entrepreneurship, lotteries, gambling) in one coherent framework. Notably, overoptimistic actions are not universal, but have plausible limits. We characterize under which situations overoptimistic actions are most likely to occur and under which circumstances choices should be rational or even pessimistic. |
| Keywords: | Focusing,Salience,Framing,Overoptimism |
| JEL: | D03 D11 D90 |
| Date: | 2017 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:dicedp:279&r=upt |
| By: | Jean-Michel Grandmont (ICEF; Department of Economics, University Ca’ Foscari di Venezia; CREST; RIEB Fellow; University of Kobe) |
| Abstract: | We evaluate the income elasticity of the aggregate budget share spent on a sub-group of commodities, in a competitive framework, by a continuum of agents having the same income, but heterogeneous behavior described by an "homothetic preferences scaling factor" having a bounded Pareto distribution in the population. If individual budget share increases globally significantly in the limit from low to large incomes, aggregate budget share is locally increasing with medium range incomes when the logarithm of the heterogeneity factor has an increasing (exponential) density with a large support. Aggregate income elasticity converges to that exponential density parameter when its support becomes infinitely large. Symmetric results hold in the decreasing case. Applications are made to market expenditures, wealth effects on portfolio choice with many risky assets, concave expenditures, that are compatible with standard (expected) utility maximization or other "behavioral" decision making processes. |
| Keywords: | Behavioral heterogeneity; aggregation; preference scales; aggregate income elasticity; power law; Pareto distribution; exponential distribution; market demand; wealth effect on aggregate portfolio choices |
| URL: | http://d.repec.org/n?u=RePEc:crs:wpaper:2017-11&r=upt |
| By: | Maria Adelaida Lopera; Steeve Marchand |
| Abstract: | We study how social interactions influence entrepreneurs' attitudes toward risk. We conduct two risk-taking experiments within workshops organized for young Ugandan entrepreneurs. Between the two experiments, the entrepreneurs participate in a networking activity where they build relationships and discuss with each other. We collect detailed data on peer network formation and on participants' choices before and after the networking activity. Our design implicitly controls for homophily effects (i.e. the tendency of individuals to develop relationships with people who have similar characteristics). We find that risk aversion is affected by social conformity. Participants tend to become more (less) risk averse in the second experiment if the peers they discuss with are on average more (less) risk averse in the first experiment. This suggests that social interactions play a role in shaping risk preferences. |
| Keywords: | Preference, Risk aversion, Entrepreneur, Social norms |
| JEL: | D03 D81 M13 Z13 |
| Date: | 2017 |
| URL: | http://d.repec.org/n?u=RePEc:lvl:piercr:2017-21&r=upt |
| By: | Eizo Akiyama (Faculty of Engineering, Information and Systems, University of Tsukuba - University of Tsukuba); Nobuyuki Hanaki (GREDEG - Groupe de Recherche en Droit, Economie et Gestion - UNS - Université Nice Sophia Antipolis - UCA - Université Côte d'Azur - CNRS - Centre National de la Recherche Scientifique - UCA - Université Côte d'Azur); Ryuichiro Ishikawa (Faculty of Engineering, Information and Systems, University of Tsukuba - University of Tsukuba) |
| Abstract: | To what extent is the observed mispricing in experimental asset markets caused by strategic uncertainty and by confusion? We address this question by comparing subjects' initial price forecasts in two market environments: one with six human traders, and the other with one human and five computer traders. We find that both strategic uncertainty and confusion contribute equally to the median initial forecast deviation from the fundamental value. The effect of strategic uncertainty is greater for subjects with a perfect score in the Cognitive Reflection Test, and it is not significant for those with low scores. |
| Keywords: | Experiment, Strategic uncertainty,Bounded rationality, Asset markets, Computer traders, Cognitive Reflection Test |
| Date: | 2017–10–24 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:halshs-01294917&r=upt |
| By: | Jaroslav Borovička; John Stachurski |
| Abstract: | We study existence, uniqueness and stability of solutions for a class of discrete time recursive utilities models. By combining two streams of the recent literature on recursive preferences - one that analyzes principal eigenvalues of valuation operators and another that exploits the theory of monotone concave operators - we obtain conditions that are both necessary and sufficient for existence and uniqueness. We also show that the natural iterative algorithm is convergent if and only if a solution exists. Consumption processes are allowed to be nonstationary. |
| JEL: | D81 G11 |
| Date: | 2017–12 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:24162&r=upt |
| By: | Jorgen-Vitting Andersen (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Roy Cerqueti (University of Macerata); Giulia Rotundo (Sapienza University [Rome]) |
| Abstract: | This paper proposes a stochastic model for describing rational expectations. The context is systemic risk, with interconnected components of a unified system. The evolution dynamics leading to the failure of the system is explored either under a theoretical point of view as well as through an extensive scenario analysis. |
| Keywords: | Rational expectation,stochastic system,systemic risk,evolutionary economics |
| Date: | 2017–12 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-01673338&r=upt |
| By: | Rahul Deb; Yuichi Kitamura; John K. -H. Quah; J\"org Stoye |
| Abstract: | We develop a model of demand where consumers trade-off the utility of consumption against the disutility of expenditure. This model is appropriate whenever a consumer's demand over a $\it{strict}$ subset of all available goods is being analyzed. Data sets consistent with this model are characterized by the absence of revealed preference cycles over prices. For the random utility extension of the model, we devise nonparametric statistical procedures for testing and welfare comparisons. The latter requires the development of novel tests of linear hypotheses for partially identified parameters. Our applications on national household expenditure data provide support for the model and yield informative bounds concerning welfare rankings across different prices. |
| Date: | 2018–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1801.02702&r=upt |
| By: | Monica Novackova (Department of Economics, University of Sussex); Richard S.J. Tol (Department of Economics, University of Sussex; Department of Spatial Economics, Vrije Universiteit, Amsterdam; Institute for Environmental Studies, Vrije Universiteit, Amsterdam; Tinbergen Institute, Amsterdam; CESifo, Munich) |
| Abstract: | We explore an unprecedented dataset of almost 6000 observations to identify main predictors of climate knowledge, climate risk perception and willingness to pay for climate change mitigation. Among nearly 70 potential explanatory variables we detect the most important ones using multisplit lasso estimator. Importantly, we test significance of individuals' preferences about time, risk and equity. Our study is innovative as these behavioural characteristics were recorded by including experimental methods into a live sample survey. This unique way of data collection combines advantages of survey and experiments. The most important predictors of environmental attitudes are numeracy, cognitive ability, ideological world-view and inequity aversion. |
| Keywords: | climate change; climate knowledge; climate policy; lasso; risk perception; willingness to pay |
| JEL: | Q54 Q58 D80 |
| Date: | 2018–01 |
| URL: | http://d.repec.org/n?u=RePEc:sus:susewp:0318&r=upt |
| By: | Rosen Valchev (Boston College); Cosmin Ilut (Duke University) |
| Abstract: | In this paper, we study a bounded rationality model where agents find it costly to solve economic problems, even if state variables are perfectly observed. We analyze how this hypothesis is complementary, but distinct, from the traditional approach of `information constraints', where agents are limited in the proper perception of state variables. We consider several classic economic problems, with a particular focus on macroeconomic models, to derive observable implications that differentiate our proposed friction from the existing bounded rationality approaches. The model generates state-dependent decision rules characterized by inaction, as well as by under- or over-reaction. In terms of policy implications, we show how the cognition friction can change inference on the underlying sources of economic mechanisms and shocks. |
| Date: | 2017 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed017:1285&r=upt |
| By: | Francois Geerolf (University of California, Los Angeles) |
| Abstract: | This paper provides a new qualitative intuition for the existence of discount rates in asset pricing. In a class of models with financial frictions, discount rates arise across securities with similar cash flows, as apparent failures of the law of one price, whenever capital providers are heterogeneous in efficiency. The theory is shown to be a candidate explanation for some cross-sectional and time series anomalies. Discount rates vary across assets and over time, for reasons unrelated to curvature in utility functions. Although some implications are similar, this theory is different from intermediary and margin based asset pricing: for example, spreads are positive, even with only risk-neutral agents, or on securities with deterministic cash flows. Finally, macroeconomic implications of the theory for investment and employment are discussed. |
| Date: | 2017 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed017:1227&r=upt |
| By: | N. Packham |
| Abstract: | In a continuous-time setting where a risk-averse agent controls the drift of an output process driven by a Brownian motion, optimal contracts are linear in the terminal output; this result is well-known in a setting with moral hazard and -under stronger assumptions - adverse selection. We show that this result continues to hold when in addition reservation utilities are type-dependent. This type of problem occurs in the study of optimal compensation problems involving competing principals. |
| Date: | 2018–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1801.04080&r=upt |