nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2018‒03‒12
nineteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Risk Aversion, Prudence and Temperance in Gain and Loss: are we all Schizophrenics? By Marielle Brunette; Julien Jacob
  2. Signaling Probabilities in Ambiguity: on the impact of vague news By Dmitri Vinogradov; Yousef Makhlouf
  3. Balancing Expected and Worst-Case Utility in Contracting Models with Asymmetric Information and Pooling By Kerkkamp, R.B.O.; van den Heuvel, W.; Wagelmans, A.P.M.
  4. Discriminating between Models of Ambiguity Attitude: A Qualitative Test By Robin Cubitt; Gijs van de Kuilen
  5. Ambiguity and the historical equity premium By Fabrice Collard; Sujoy Mukerji
  6. Optimal Taxes on Capital in the OLG Model with Uninsurable Idiosyncratic Income Risk By Krueger, Dirk; Ludwig, Alexander
  7. The Strength of Sensitivity to Ambiguity By Robin Cubitt; Gijs van de Kuilen
  8. Simple Bounds for Transaction Costs By Bruno Bouchard; Johannes Muhle-Karbe
  9. Modelling the choice between and the costs of multiple-use vs. specialized forest management By Serge Garcia; Claudio Petucco; Bo Jellesmark Thorsen; Suzanne Elizabeth Vedel
  10. Decision-making within the Household: The Role of Autonomy and Differences in Preferences By Alem, Yonas; Hassen, Sied; Köhlin, Gunnar
  11. Human Ethics and Virtues: Rethinking the Homo-Economicus Model By Sanjit Dhami
  12. “Prevent or Cure”? Trading in the face of left-skewed binary lotteries By Julien Jacob; Marielle Brunette; Louis Eeckhoudt
  13. Does uncertainty affect real activity? Evidence from state-level By Haroon Mumtaz;
  14. Other-Regarding Preferences in Organizational Hierarchies By Kemal Saygili; Serkan Kucuksenel
  15. A Democratic Measure of Household Income Growth: Theory and Application to the United Kingdom By Andrew Aitken; Martin Weale
  16. Risk Everywhere: Modeling and Managing Volatility By Bollerslev, Tim; Hood, Benjamin; Huss, John; Pedersen, Lasse Heje
  17. Limited consideration and limited data: revealed preference tests and observable restrictions By Yuta Inoue; Koji Shirai
  18. Expectation-driven asset price fluctuations under the spirit of capitalism hypothesis: The role of heterogeneity By Lise Clain-Chamosset-Yvrard
  19. A New Predictor of U.S. Real Economic Activity: The S&P 500 Option Implied Risk Aversion By Renato Faccini; Eirini Konstantinidi

  1. By: Marielle Brunette (UMR INRA – AgroParisTech, Laboratoire d’Economie Forestière, 54042 Nancy Cedex, France); Julien Jacob (BETA, University of Lorraine, 13 Place Carnot – CO n°70026. 54035 NANCY Cedex – France)
    Abstract: In this paper, our aims are of three orders: i) to characterize the individuals’ preferences towards risk, prudence and temperance in the gain and loss domain; ii) to analyze potential correlations between domains, for a given feature of preferences, and between features, for a given domain; iii) to identify potential determinants of these individual preferences. For that purpose, we conducted a lab experiment eliciting risk aversion, prudence and temperance in the two domains and collected information about individuals’ characteristics. First, our results indicate that participants are risk averse, prudent and temperate in the gain domain while risk averse, imprudent and temperate in the loss domain. Second, we observed that risk aversion in the gain and loss domains is positively and significantly correlated. The same result applies for prudence and temperance. We also identified that behaviors in terms of risk aversion, prudence and temperance are all bilaterally correlated in the gain and loss domains, except for risk aversion and temperance in the gain domain. Finally, we found that the determinants of the individual’s preferences generally depend on the domain and the feature.
    Keywords: risk aversion, prudence, temperance, experiment, correlations, determinants
    JEL: C91 D81
    Date: 2017–07
  2. By: Dmitri Vinogradov; Yousef Makhlouf
    Abstract: Vague, or imprecise, news may affect decisions by changing either the funda- mentals, or the associated uncertainty, or both. We show response to vague news is shaped by ambiguity attitudes, yet with qualitative differences for dif- ferent levels of risk, on top of ambiguity, conveyed. The decision functional con- sists of a probabilistic term and an ambiguity premium; the latter depends on both risk and ambiguity, implying differential responses of ambiguity-neutral, -averse and -seeking subjects to probabilistic, as well as non-probabilistic news. In a two-color Ellsberg experiment with signals we obtain ambiguity attitudes matter more for non-probabilistic and less for probabilistic, though still impre- cise news. For vague news conveying a relatively high probability of success, subjects exhibit insensitivity to the ambiguity component, unless explicitly facing similar news of di§erent degrees of precision. Possible explanation is in either flat ambiguity premiums, or the cognitive inability to process the risky and the ambiguous components simultaneously.
    Keywords: ambiguity-aversion, ambiguity premium, Ellsberg experi- ment, vague news.
    JEL: C90 D01 D81
    Date: 2017–12
  3. By: Kerkkamp, R.B.O.; van den Heuvel, W.; Wagelmans, A.P.M.
    Abstract: We consider a principal-agent contracting problem between a seller and a buyer, where the buyer has single-dimensional private information. The buyer's type is assumed to be continuously distributed on a closed interval. The seller designs a menu of finitely many contracts by pooling the buyer types a priori using a partition scheme. He maximises either his minimum utility, his expected utility, or a combination of both (a multi-objective approach). For each variation, we determine tractable reformulations and the optimal menu of contracts under certain conditions. These results are applied to a contracting problem with quadratic utilities. We show that the optimal objective value is completely determined by the partition scheme, a single aggregate instance parameter, and a parameter encoding the seller's guaranteed obtained utility. This enables us to derive the optimal partition and exact performance guarantees. Our analysis shows that the seller should always offer at least two contracts in order to have reasonable performance guarantees, resulting in at least 88% of the expected utility compared to offering infinitely many contracts. By also optimising obtained worst-case utility, he can potentially achieve only 64% of the maximum expected utility.
    Keywords: mechanism design, asymmetric information, pooling of contracts, multi-objective optimisation
    Date: 2018–01–09
  4. By: Robin Cubitt (University of Nottingham); Gijs van de Kuilen (Tilburg University)
    Abstract: During recent decades, many new models have emerged in pure and applied economic theory according between Epstein (2010) and Klibanoff et al. (2012) identified a notable behavioral issue that distinguishes sharply between two classes of models of ambiguity sensitivity that are importantly different. The two classes are exemplified by the -MEU model and the smooth ambiguity model, respectively; and the issue is whether or not a desire to hedge independently resolving ambiguities contributes to an ambiguity averse preference for a randomized act. Building on this insight, we implement an experiment whose design provides a qualitative test that discriminates between the two classes of models. Among subjects identified as ambiguity sensitive, we find greater support for the class exemplified by the smooth ambiguity model; the relative support is stronger among subjects identified as ambiguity averse. This finding has implications for applications which rely on specific models of ambiguity preference.
    Keywords: Ambiguity sensitivity; ambiguity attitude; testing models of ambiguity sensitive preference
    JEL: C91 D01 D03 D81 G02
    Date: 2017–08–18
  5. By: Fabrice Collard (Department of Economics, University of Bern); Sujoy Mukerji (Queen Mary University of London)
    Abstract: This paper assessed the quantitative impact of ambiguity on historically observed financial asset returns and growth rates. The single agent, in a dynamic exchange economy, treats the conditional uncertainty about the consumption and dividends next period as ambiguous. We calibrate the agent's ambiguity aversion to match only the first moment of the risk-free rate in data and measure the uncertainty each period conditional on the actual, observed histroy of (U.S.) macroeconomic growth outcomes. Ambiguity aversion accentuates the conditional uncertainty endogenously in a dynamic way, depending on the history; e.g., it increases during recessions. We show the model implied time series of asset returns substantially match the first and second conditional moments of observed return dynamics. In particular, we find the time-series properties of our mdoel generated equity premium, which may be regarded as an index measure of revealed uncertainty, relates closely to those of the macroeconomic uncertainty indices developed recently in Jurado, Ludvigson, and Ng (2015) and Carriero, Clark, and Marcellino (2017).
    Keywords: Ambiguity aversion, Asset pricing, Equity premium puzzle, Time-varying uncertainty, Uncertainty shocks
    JEL: G12 E21 D81 C63
    Date: 2017–09–15
  6. By: Krueger, Dirk; Ludwig, Alexander
    Abstract: We characterize the optimal linear tax on capital in an Overlapping Generations model with two period lived households facing uninsurable idiosyncratic labor income risk. The Ramsey government internalizes the general equilibrium feedback of private precautionary saving. For logarithmic utility our full analytical solution of the Ramsey problem shows that the optimal aggregate saving rate is independent of income risk. The optimal time-invariant tax on capital is increasing in income risk. Its sign depends on the extent of risk and on the Pareto weight of future generations. If the Ramsey tax rate that maximizes steady state utility is positive, then implementing this tax rate permanently generates a Pareto-improving transition even if the initial equilibrium is dynamically efficient. We generalize our results to Epstein-Zin-Weil utility and show that the optimal steady state saving rate is increasing in income risk if and only if the intertemporal elasticity of substitution is smaller than 1.
    Keywords: Idiosyncratic Risk; Overlapping Generations; precautionary saving; Taxation of Capital
    JEL: E21 H21 H31
    Date: 2018–02
  7. By: Robin Cubitt (University of Nottingham); Gijs van de Kuilen (Tilburg University)
    Abstract: We report an experiment where each subject's ambiguity sensitivity is measured by an ambiguity premium, a concept analogous to and comparable with a risk premium. In our design, some tasks feature known objective risks and others uncertainty about which subjects have imperfect, heterogeneous, information (''ambiguous tasks''). We show how the smooth ambiguity model can be used to calculate ambiguity premia. A distinctive feature of our approach is estimation of each subject's subjective beliefs about the uncertainty in ambiguous tasks. We find considerable heterogeneity among subjects in beliefs and ambiguity premia; and that, on average, ambiguity sensitivity is about as strong as risk sensitivity.
    Keywords: Ambiguity sensitivity; ambiguity attitude; measuring strength of ambiguity sensitivity; smooth ambiguity model; ambiguity premium
    JEL: C91 D01 D03 D80 G02
    Date: 2017–09–15
  8. By: Bruno Bouchard; Johannes Muhle-Karbe
    Abstract: Using elementary arguments, we derive $\L_{p}$-error bounds for the approximation of frictionless wealth process in markets with proportional transaction costs. For utilities with bounded risk aversion, these estimates yield lower bounds for the frictional value function, which pave the way for its asymptotic analysis using stability results for viscosity solutions. Using tools from Malliavin calculus, we also derive simple sufficient conditions for the regularity of frictionless optimal trading strategies, the second main ingredient for the asymptotic analysis of small transaction costs.
    Date: 2018–02
  9. By: Serge Garcia (UMR INRA – AgroParisTech, Laboratoire d’Economie Forestière, 54042 Nancy Cedex, France); Claudio Petucco (UMR INRA – AgroParisTech, Laboratoire d’Economie Forestière, 54042 Nancy Cedex, France); Bo Jellesmark Thorsen (Department of Food and Resource Economics and Center for Macro Ecology, Evolution and Climate, University of Copenhagen, Rolighedsvej 23, DK-1958 Frederiksberg C,; Suzanne Elizabeth Vedel (Department of Food and Resource Economics, University of Copenhagen, Rolighedsvej 23, DK-1958 Frederiksberg C, Denmark,
    Abstract: Forests provide ecosystem services jointly with timber production. In some cases, private forest owners implement management actions in order to enhance the provision of such services. They may get direct benefits from this decision such as private amenity values or effects on (e.g., hunting), they may have altruist traits in their utility function for providing public goods (e.g., biodiversity conservation, carbon sequestration), or they may be incited for by a public authority and compensated for the costs. Specifically, this paper focuses on the decision of setting aside forest land. It raises the more general question of the efficiency of multiple-use vs. specialized management of forest lands. We propose an econometric analysis to identify factors of the set-aside choice and to measure the impact of this decision on forest management costs. A flexible cost function is modelled and estimated for both types of management. The percentages of old/mature deciduous and old/mature coniferous forests are used as biodiversity and carbon indicators. Results show that the set-aside choice depends on the landowners’ income and on their socio-economic characteristics. Set-aside decision has a significant and positive impact on the management costs. This implies that the additional private and public benefits achieved from specialized relative to multiple-use management should exceed this cost premium.
    Keywords: Forest; multiple-use vs. specialized management, household production model, cost function, corner solution, recursive mixed system
    JEL: Q41 Q48 Q23
    Date: 2017–04
  10. By: Alem, Yonas (Department of Economics, School of Business, Economics and Law, Göteborg University); Hassen, Sied (Environment and Climate Research Center of the Ethiopian Development Research Institute); Köhlin, Gunnar (Department of Economics, School of Business, Economics and Law, Göteborg University)
    Abstract: We use a field experiment to identify how differences in preferences and autonomy in decision-making result in sub-optimal adoption of technologies that can maximize the welfare of all members of the household. We create income-earning opportunities and elicit willingness- to-pay (WTP) for energy-efficient cookstoves through a real stove purchase experiment with randomly chosen wives, husbands and couples. Experimental results suggest that women, who often are responsible for cooking and for collecting fuelwood, reveal a higher preference than men for the improved stoves. Using an instrumental variables tobit estimator, we show that women who have higher decision-making autonomy reveal higher WTP than those who have lower decision-making autonomy. A follow-up survey conducted 15 months after the stove purchase show that autonomy does not affect stove use. Our findings highlight the importance of considering division of labor, different preferences, and bargaining power differences within the household when promoting adoption of new household technologies.
    Keywords: Preference Difference; Decision-making; Autonomy; Willingness-to-pay
    JEL: C93 D13 O12 Q56
    Date: 2018–03
  11. By: Sanjit Dhami
    Abstract: The neoclassical model in economics envisages humans as amoral and self-regarding (Econs). This model, also known as the homo-economicus model, is not consistent with the empirical evidence. In light of the evidence, the continued use of the homo-economicus model is baffling. It also stymies progress in the field by putting the burden of adjustment on auxiliary assumptions that need to compensate for an unrealistic picture of human motivation and behavior. This essay briefly outlines the evidence for a more inclusive picture of humans in which ethics and morality play a central role. It argues for replacing the homo-economicus model with a homo-behavioralis model that has already enabled great progress to be made in the field of behavioral economics.
    Keywords: ethics, morality, intrinsic motivation, consequentialistic choices, lying-aversion, guilt-aversion, markets and morality, moral balancing, self-image, self-serving justifications, partial lying, third party punishment, delegation, social identity, moral suasion
    JEL: D90 D64
    Date: 2017
  12. By: Julien Jacob (BETA, University of Lorraine, 13 Place Carnot – CO n°70026. 54035 NANCY Cedex – France,; Marielle Brunette (UMR INRA – AgroParisTech, Laboratoire d’Economie Forestière, 54042 Nancy Cedex, France); Louis Eeckhoudt (IESEG School of Management)
    Abstract: This paper focuses on the individual's trade-obetween a reduction in the probability of occurrence of a negative event and a reduction in its magnitude for a risk averse decision-maker. For that purpose, we propose a theoretical model based on left-skewed binary lotteries with lottery A associated to a lower damage and a higher probability of occurrence than B. We show that the main determinant of the individual's choice is the expectations of the lotteries. When the expectations of A is higher or equal to the one of B, then any risk averse decision-maker will prefer A to B due to second-order stochastic dominance. However, when the lottery B is associated to a higher expectation than A, then additional assumptions on individual's prudence and temperance are required. We also test experimentally our theoretical predictions. Finally, we provide three possible applications, and draw related policy recommendations.
    Keywords: Left-skewed risk, binary lotteries, prudence, temperance
    JEL: C91 D81
    Date: 2017–05
  13. By: Haroon Mumtaz (Queen Mary University of London);
    Abstract: We use variation in the effect of US-wide or global uncertainty on state-level uncertainty to identify the impact of this shock on real activity. We nd that increases in uncertainty do have an adverse impact on real income, employment and unemployment. Thus, uncertainty shocks can be a source of economic fluctuations.
    Keywords: Uncertainty shocks, Instrumental variables, US states
    JEL: C15 C32 E32
    Date: 2017–12–25
  14. By: Kemal Saygili (Department of Economics, Middle East Technical University, Ankara, Turkey); Serkan Kucuksenel (Department of Economics, Middle East Technical University, Ankara, Turkey)
    Abstract: In this paper, we provide new theoretical insights about the role of collusion in organizational hierarchies by combining the standard principal-supervisor-agent framework with a theory of social preferences. Extending Tirole’s (1986) model of hierarchy with the inclusion of Fehr and Schmidt’s (1999) distributional other-regarding preferences approach, the links between inequity aversion, collusive behavior throughout the levels of a hierarchy and the changes in optimal contracts are studied. It turns out that other-regarding preferences do change the collusive behavior among parties depending on the nature of both the agent’s and the supervisor’s other-regarding preferences. Most prominent impact is on the optimal effort levels. When the agent is inequity averse principal can exploit this fact to make agent exert higher effort level than she would otherwise. In order to satisfy the participation constraint of the supervisor, the effort level induced for the agent becomes lower when the supervisor is status seeker, and it is higher when the supervisor is inequity averse.
    Keywords: Other-Regarding Preferences, Hierarchy, Collusive Behavior, Optimal Contract Design
    JEL: D90 D82 L22
    Date: 2018–02
  15. By: Andrew Aitken; Martin Weale
    Abstract: This paper develops a price and quantity system of indicators structured round Atkinson's concept of inequality aversion. A democratic indicator of income growth, weighting each household's growth experience equally, is shown to result when Prais' democratic price index is used to deflate the geometric mean of equivalised household income. A welfare interpretation of the democratic indicator of income growth is provided and it is shown that, with heterogeneous but homothetic preferences, the deflator can serve as a common scaling social cost of living index when applied to income as well as to consumption. Application to United Kingdom household data suggests that, over the interval 2005/6-2015/6 democratic real equivalised household income grew by 0.20 per cent per annum while the plutocratic equivalent grew by 0.52 per cent per annum.
    Keywords: Real Income, Inequality Aversion, Welfare Indicator, Cost of Living
    JEL: I31 D12 E21
    Date: 2018–02
  16. By: Bollerslev, Tim; Hood, Benjamin; Huss, John; Pedersen, Lasse Heje
    Abstract: Based on a unique high-frequency dataset for more than fifty commodities, currencies, equity indices, and fixed income instruments spanning more than two decades, we document strong similarities in realized volatilities patterns across assets and asset classes. Exploiting these similarities within and across asset classes in panel-based estimation of new realized volatility models results in superior out-of-sample risk forecasts, compared to forecasts from existing models and more conventional procedures that do not incorporate the information in the high-frequency intraday data and/or the similarities in the volatilities. A utility-based framework designed to evaluate the economic gains from risk modeling highlights the interplay between parsimony of model specification, transaction costs, and speed of trading in the practical implementation of the different risk models.
    Keywords: high-frequency data; Market and volatility risk; realized utility; realized volatility; risk modeling and forecasting; risk targeting; volatility trading
    JEL: C22 C51 C53 C58
    Date: 2018–02
  17. By: Yuta Inoue (Graduate School of Economics, Waseda University); Koji Shirai (School of Economics, Kwansei Gakuin University)
    Abstract: This paper develops revealed preference tests for choices under limited consideration, allowing a partially observed data set. Our tests are based on a common structure of various limited consideration models, and cover leading theories in the literature including the limited attention model, the rationalization model, the categorize-then-choose model, and the rational shortlist model. While tests involve combinatorial calculation, by applying the backtracking method, we perform simulations to numerically compare observable restrictions of various models. As a result, we find remarkable differences in observable restrictions across models.
    Keywords: Revealed preference; Limited consideration; Limited attention; Rational shortlisting; Bounded rationality; Bronars test
    JEL: C6 D1 D8
    Date: 2018–03
  18. By: Lise Clain-Chamosset-Yvrard (Univ Lyon, Université Lumière Lyon 2, GATE L-SE UMR 5824, F-69130 Ecully, France)
    Abstract: In this paper, I study how heterogeneity amongst agents affects the occurrence of expectation-driven asset price fluctuations in a pure exchange economy à la Lucas, with infinitely-lived households, under the hypothesis of spirit of capitalism. I consider heterogeneous households in terms of preferences, endowments and initial wealth, and capture the spirit of capitalism through preferences for wealth. Preferences for wealth are the key element of this paper in a twofold aspect. First, they explain the occurrence of asset price fluctuations driven by self-fulfilling changes in expectations. Second, heterogeneity in endowments affects asset price level and dynamics only if preferences are heterogeneous. For instance, if agents with the strongest spirit of capitalism are also the rich in terms of endowments, heterogeneity in endowments heightens the asset price level in the long run, and destabilizes by enlarging the range of parameter values for which expectation-driven asset price fluctuations occur.
    Keywords: Asset pricing model, Spirit of Capitalism, Heterogeneity, Expectation-driven fluctuations
    JEL: C62 E21 E32
    Date: 2018
  19. By: Renato Faccini (Queen Mary University of London); Eirini Konstantinidi (Alliance Manchester Business School - Accounting and Finance division)
    Abstract: We propose a new predictor of U.S. real economic activity (REA), namely the representative investor’s implied relative risk aversion (IRRA) extracted from S&P 500 option prices. IRRA is forward-looking and hence, it is expected to be related to future economic conditions. We document that U.S. IRRA predicts U.S. REA both in- and out-of-sample once we control for well-known REA predictors and take into account their persistence. An increase (decrease) in IRRA predicts a decrease (increase) in REA. We extend the empirical analysis by extracting IRRA from the South Korea, UK, Japanese and German index option markets. We find that South Korea IRRA predicts the South Korea REA both in- and out-of-sample, as expected given the high liquidity of its index option market. We show that a parsimonious yet flexible production economy model calibrated to the U.S. economy can explain the documented negative relation between risk aversion and future economic growth.
    Keywords: Option prices, Risk aversion, Risk-neutral moments, Real Economic Activity, Production economy model
    JEL: E44 G13 G17
    Date: 2018–01

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