
on Utility Models and Prospect Theory 
Issue of 2018‒03‒19
sixteen papers chosen by 
By:  Sujoy Mukerji (Queen Mary University of London); Ian Jewitt (Nuffield College, Oxford University) 
Abstract:  We investigate what it means for one act to be more ambiguous than another. The question is evidently analogous to asking what makes one prospect riskier than another, but beliefs are neither objective nor representable by a unique probability. Our starting point is an abstract class of preferences constructed to be (strictly) partially ordered by a more ambiguity averse relation. First, we define two notions of more ambiguous with respect to such a class. A more ambiguous (I) act makes an ambiguity averse decision maker (DM) worse off but does not affect the welfare of an ambiguity neutral DM. A more ambiguous (II) act adversely affects a more ambiguity averse DM more, as measured by the compensation they require to switch acts. Unlike more ambiguous (I), more ambiguous (II) does not require indifference of ambiguity neutral elements to the acts being compared. Second, we implement the abstract definitions to characterize more ambiguous (I) and (II) for two explicit preference families: a maxmin expected utility and smooth ambiguity. Thirdly, we give applications to the comparative statics of more ambiguous in a standard portfolio problem and a consumptionsaving problem. 
Keywords:  Ambiguity, Uncertainty, Knightian Uncertainty, Ambiguity Aversion, Uncertainty aversion, Ellsberg paradox, Comparative statics, Singlecrossing, More ambiguous, Portfolio choice 
JEL:  C44 D80 D81 G11 
Date:  2017–07–20 
URL:  http://d.repec.org/n?u=RePEc:qmw:qmwecw:828&r=upt 
By:  Sujoy Mukerji (Queen Mary University of London); Peter Klibanoff (Kellogg School of Management, Northwestern University) 
Abstract:  Since at least de Finetti [7], preference symmetry assumptions have played an important role in models of decision making under uncertainty. In the cur rent paper, we explore (1) the relationship between the symmetry assumption of Klibanoff, Mukerji and Seo (KMS) [21] and alternative symmetry assumptions in the literature, and (2) assuming symmetry, the relationship between the set of relevant measures, shown by KMS [21] to reflect only perceived ambiguity, and the set of measures (which we will refer to as the Bewley set) developed by Ghirardato, Maccheroni and Marinacci [14], Nehring [24, 25] and Ghirardato and Siniscalchi [15, 16]. This Bewley set is the main alternative offered in the literature as possibly representing perceived ambiguity. Regarding symmetry assumptions, we show that, under relatively mild conditions, a variety of preference symmetry conditions from the literature (including that in KMS [21]) are equivalent. In KMS [21], we showed that, under symmetry, the Bewley set and the set of relevant measures are not always the same. Here, we establish a preference condition, No Half Measures, that is necessary and sufficient for the two to be same under symmetry. This condition is rather stringent. Only when it is satisfied may the Bewley set be interpreted as reflecting only perceived ambiguity and not also taste aspects such as ambiguity aversion. 
Keywords:  Symmetry, beliefs, ambiguity, ambiguity aversion, model uncertainty, Ellsberg 
JEL:  D01 D80 D81 D83 
Date:  2017–07–20 
URL:  http://d.repec.org/n?u=RePEc:qmw:qmwecw:829&r=upt 
By:  Matthew Polisson (University of St Andrews); John K.H. Quah (Johns Hopkins University) 
Abstract:  We develop a nonparametric procedure, called the lattice method, for testing the consistency of contingent consumption data with a broad class of models of choice under risk and under uncertainty. Our method allows for risk loving and elation seeking behavior and can be used to calculate, via Afriat’s efficiency index, the magnitude of violations from a particular model of choice. We evaluate the performance of different models (including expected utility, disappointment aversion, rank dependent utility, meanvariance utility, and stochastically monotone utility) in the data collected by Choi et al. (2007), in terms of pass rates, power, and predictive success. 
Keywords:  expected utility, rank dependent utility, disappointment aversion, Bronars power, predictive success, generalized axiom of revealed preference, first order stochastic dominance, meanvariance utility, Afriat’s efficiency index 
JEL:  C14 C60 D11 D12 D81 
Date:  2017–04–26 
URL:  http://d.repec.org/n?u=RePEc:qmw:qmwecw:822&r=upt 
By:  Dohmen, Thomas (University of Bonn and IZA); Falk, Armin (briq and University of Bonn); Huffman, David (University of Pittsburgh); Sunde, Uwe (LMU) 
Abstract:  This paper focuses on the relationship between cognitive ability and decision making under risk and uncertainty. We begin by clarifying some important distinctions between concepts and measurement of risk preference and cognitive ability and then take stock of what is known empirically on the connections between cognitive ability and measured risk preferences. 
Keywords:  ; 
Date:  2018–03–05 
URL:  http://d.repec.org/n?u=RePEc:rco:dpaper:76&r=upt 
By:  Dirk Krueger; Alexander Ludwig 
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 timeinvariant 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 Paretoimproving transition even if the initial equilibrium is dynamically efficient. We generalize our results to EpsteinZinWeil 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. 
JEL:  E21 H21 H31 
Date:  2018–02 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:24335&r=upt 
By:  Bihary, Zsolt; Dömötör, Barbara 
Abstract:  We explain the diversity of corporate hedging behavior in a single model. The hedging ratio is obtained by maximizing expected utility that is a combination of the corporate level utility and a component that models the incentives of the financial manager. We derive a theoretical model that gives back the classic result of the literature if the financial manager has no other incentive than to maximize corporate utility. In the case the financial manager expects that his evaluation will be based exclusively on the financial profit (the profit of the hedging transactions), being risk averse, he decides not to hedge at all. The hedging ratio depends on the weight of these contradictory effects. We test our theoretical results on Hungarian corporate survey data. 
Keywords:  corporate hedging, corporate utility, manager incentives 
JEL:  F13 G32 G34 
Date:  2018–02–26 
URL:  http://d.repec.org/n?u=RePEc:cvh:coecwp:2018/01&r=upt 
By:  Julie Moschion (Melbourne Institute: Applied Economic & Social Research, The University of Melbourne); Nattavudh Powdthavee (Warwick Business School; and Centre for Economic Performance, London School of Economics) 
Abstract:  This paper provides an empirical test of the rational addiction model, used in economics to model individuals’ consumption of addictive substances, versus the utility misprediction model, used in psychology to explain the discrepancy between people’s decision and their subsequent experiences. By exploiting a unique data set of disadvantaged Australians, we provide longitudinal evidence that a drop in life satisfaction tends to precede the use of illegal/street drugs. We also find that the abuse of alcohol, the daily use of cannabis and the weekly use of illegal/street drugs in the past 6 months relate to lower current levels of life satisfaction. This provides empirical support for the utility misprediction model. Further, we find that the decrease in life satisfaction following the consumption of illegal/street drugs persists 6 months to a year after use. In contrast, the consumption of cigarettes is unrelated to life satisfaction in the close past or the near future. Our results, though only illustrative, suggest that measures of individual’s subjective wellbeing should be examined together with data on revealed preferences when testing models of rational decisionmaking. 
Keywords:  Life satisfaction, rational addiction, drugs, homeless, Australia, happiness 
JEL:  D03 I12 I18 I30 
Date:  2017–12 
URL:  http://d.repec.org/n?u=RePEc:iae:iaewps:wp2017n32&r=upt 
By:  Frank Huettner, (ESMT European School of Management and Technology); Tamer Boyaci, (ESMT European School of Management and Technology); Yalcin Akcay (Melbourne Business School) 
Abstract:  Consumers often do not have complete information about the choices they face and therefore have to spend time and effort in acquiring information. Since information acquisition is costly, consumers tradeoff the value of better information against its cost, and make their final product choices based on imperfect information. We model this decision using the rational inattention approach and describe the rationally inattentive consumer’s choice behavior when she faces alternatives with different information costs. To this end, we introduce an information cost function that distinguishes between direct and implied information. We then analytically characterize the optimal choice probabilities. We find that nonuniform information costs can have a strong impact on product choice, which gets particularly conspicuous when the product alternatives are otherwise very similar. There are significant implications on how a seller should provide information about its products and how changes to the product set impacts consumer choice. For example, nonuniform information costs can lead to situations where it is disadvantageous for the seller to provide easier access to information for a particular product, and to situations where the addition of an inferior (never chosen) product increases the market share of another existing product (i.e., failure of regularity). We also provide an algorithm to compute the optimal choice probabilities and discuss how our framework can be empirically estimated from suitable choice data. 
Keywords:  discrete choice, rational inattention, information acquisition, nonuniform information costs, strong failure of regularity 
JEL:  D40 D80 
Date:  2016–08–18 
URL:  http://d.repec.org/n?u=RePEc:esm:wpaper:esmt1604_r2&r=upt 
By:  Géraldine Bocquého (Université de Lorraine, AgroParisTechINRA, BETA); Marc Deschamps (Université de Bourgogne FrancheComté, CRESE); Jenny Helstroffer (University of Lorraine, CNRS, BETA); Majlinda Joxhe (CREA, Université du Luxembourg) 
Abstract:  This paper uses the experimental setup of Tanaka et al. (2010) to measure refugees’ risk preferences. A sample of 206 asylum seekers was interviewed in 201718 in Luxembourg. Contrary to studies which focus on risk aversion in general, we analyze its components using a cumulative prospect theory (CPT) framework. We show that refugees exhibit particularly low levels of risk aversion compared to other populations and that CPT provides a better fit for modelling risk attitudes. Moreover, we include randomised temporary treatments provoking emotions and find a small significant impact on probability distortion. Robustness of the Tanaka et al. (2010) experimental framework is confirmed by including treatments regarding the embedding effect. Finally, we propose a theoretical model of refugee migration that integrates the insights from our experimental outcomes regarding the functional form of refugees’ decision under risk and the estimated parameter values. The model is then simulated using the data from our study. 
Keywords:  "Refugee migration, risk preferences, experimental economics, cumulative prospect theory, psychological priming " 
JEL:  C93 D74 D81 D91 F22 
Date:  2018 
URL:  http://d.repec.org/n?u=RePEc:luc:wpaper:1808&r=upt 
By:  Nicolas Baradel (CEREMADE, ENSAE); Bruno Bouchard (CEREMADE, PSL); David Evangelista (KAUST); Othmane Mounjid (CMAP) 
Abstract:  We model the behavior of three agent classes acting dynamically in a limit order book of a financial asset. Namely, we consider market makers (MM), highfrequency trading (HFT) firms, and institutional brokers (IB). Given a prior dynamic of the order book, similar to the one considered in the QueueReactive models [14, 20, 21], the MM and the HFT define their trading strategy by optimizing the expected utility of terminal wealth, while the IB has a prescheduled task to sell or buy many shares of the considered asset. We derive the variational partial differential equations that characterize the value functions of the MM and HFT and explain how almost optimal control can be deduced from them. We then provide a first illustration of the interactions that can take place between these different market participants by simulating the dynamic of an order book in which each of them plays his own (optimal) strategy. 
Date:  2018–02 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1802.08135&r=upt 
By:  Giancarlo Corsetti (Centre for Economic Policy Research (CEPR); Centre for Macroeconomics (CFM); University of Cambridge); Luca Dedola (Centre for Macroeconomics (CFM); European Central Bank); Sylvain Leduc (Bank of Canada) 
Abstract:  What determines the optimal monetary tradeoff between internal objectives (inflation and output gap) and external objectives (competitiveness and trade imbalances) when inefficient capital flows cause exchange rate misalignment and distort current account positions? We characterize this tradeoff analytically, using the workhorse model of modern monetary theory in open economies under incomplete markets–where inefficient capital flows and exchange rate misalignments can arise independently of nominal distortions. We derive aquadratic approximation of the utilitybased global policy loss function under fairly general assumptions on preferences and openness, and solve for the optimal targeting rules under cooperation. We show that, in economies with a low degree of exchange rate passthrough, the optimal response to inefficient capital inflows associated with real appreciation is contractionary, above and beyond the natural rate: the optimal policy curbs excessive demand at the cost of exacerbating currency overvaluation. In contrast, a high degree of passthrough, and/or low trade elasticities, warrants expansionary policies that lean against exchange rate appreciation and competitive losses, at the cost of inefficient inflation. 
Keywords:  Currency misalignments, Trade imbalences, Asset markets and risk sharing, Optimal targeting rules, International Policy, Exchange rate passthrough 
JEL:  E44 E52 E61 F41 F42 
Date:  2018–03 
URL:  http://d.repec.org/n?u=RePEc:cfm:wpaper:1806&r=upt 
By:  Pradeep Dubey 
Abstract:  We show that any transferable utility game can be represented by an assignment of facilities to the players, in which it is intuitively obvious how to allocate the total cost of the facilities. The intuitive solution in the representation turns out to be the Shapley value of the game. 
Date:  2018 
URL:  http://d.repec.org/n?u=RePEc:nys:sunysb:1801&r=upt 
By:  Bellia, Mario; Panzica, Roberto; Pelizzon, Loriana; Peltonen, Tuomas 
Abstract:  This paper analyses whether the postcrisis regulatory reforms developed by globalstandard setting bodies have created appropriate incentives for different types of market participants to centrally clear OverTheCounter (OTC) derivative contracts. Beyond documenting the observed facts, we analyze four main drivers for the decision to clear: 1) the liquidity and riskiness of the reference entity; 2) the credit risk of the counterparty; 3) the clearing member's portfolio net exposure with the Central Counterparty Clearing House (CCP) and 4) post trade transparency. We use confidential European trade repository data on singlename Sovereign Credit Derivative Swap (CDS) transactions, and show that for all the transactions reported in 2016 on Italian, German and French Sovereign CDS 48% were centrally cleared, 42% were not cleared despite being eligible for central clearing, while 9% of the contracts were not clearable because they did not satisfy certain CCP clearing criteria. However, there is a large difference between CCP clearing members that clear about 53% of their transactions and nonclearing members, even those that are subject to counterparty risk capital requirements, that almost never clear their trades. Moreover, we find that diverse factors explain clearing members' decision to clear different CDS contracts: for Italian CDS, counterparty credit risk exposures matter most for the decision to clear, while for French and German CDS, margin costs are the most important factor for the decision. Clearing members use clearing to reduce their exposures to the CCP and largely clear contracts when at least one of the traders has a high counterparty credit risk. 
Keywords:  Credit Default Swap (CDS),Central Counterparty Clearing House (CCP),European Market Infrastructure Regulation (EMIR),Sovereign 
JEL:  G18 G28 G32 
Date:  2018 
URL:  http://d.repec.org/n?u=RePEc:zbw:safewp:193&r=upt 
By:  Daniel Schwartz; Elizabeth A. Keenan; Alex Imas; Ayelet Gneezy 
Abstract:  Prior work has demonstrated that prosocial incentives – where individuals’ effort benefits a charitable organization – can be more effective than standard incentives, particularly when the stakes are low. Yet, little is known about the effectiveness of prosocial incentives on people’s decisions to participate or optin to the incentivized activity in the first place. We examined the effectiveness of prosocial incentives on people’s participation decisions using two distinct field experiments, one that sought to encourage recycling and the other that incentivized completion of effortful tasks. Across both studies, we found that individuals were more likely to avoid activities that involved prosocial incentives, compared to standard incentives, regardless of incentive size, and even when the donation was optional. Our results identify a significant limit for the scope of prosocial incentives as effective motivation tools. 
Keywords:  decision making, incentives, prosocial behavior, field experiments 
Date:  2017 
URL:  http://d.repec.org/n?u=RePEc:ces:ceswps:_6840&r=upt 
By:  ChiaLin Chang (National Chung Hsing University); Michael McAleer (Asia University, University of Sydney Business School, Erasmus University Rotterdam); WingKeung Wong (Asia University, China Medical University Hospital, Hang Seng Management College) 
Abstract:  This paper provides a review of some connecting literature in Decision Sciences, Economics, Finance, Business, Computing, and Big Data. We then discuss some research that is related to the six cognate disciplines. Academics could develop theoretical models and subsequent econometric and statistical models to estimate the parameters in the associated models. Moreover, they could then conduct simulations to examine whether the estimators or statistics in the new theories on estimation and hypothesis have small size and high power. Thereafter, academics and practitioners could then apply their theories to analyze interesting problems and issues in the six disciplines and other cognate areas. 
Keywords:  Decision sciences; economics; finance; business; computing; and big data; theoretical models; econometric and statistical models; applications. 
JEL:  A10 G00 G31 O32 
Date:  2018–03–14 
URL:  http://d.repec.org/n?u=RePEc:tin:wpaper:20180024&r=upt 
By:  Hevia, Constantino (Universidad Torcuato Di Tella); Petrella, Ivan (University of Warwick and CEPR); Sola, Martin (Universidad Torcuato Di Tella) 
Abstract:  We develop and estimate a multifactor affine model of commodity futures that allows for stochastic seasonality. We document the existence of stochastic seasonal fluctuations in commodity futures and that properly accounting for the costofcarry curve requires at least three factors. We estimate the model using data on heating oil futures and analyze the contribution of the factors to risk premia. Correctly specifying seasonality as stochastic is important to avoid erroneously assigning those fluctuations to other risk factors. We also estimate a nonlinear version of the model that imposes the zero lower bound on interest rates and find similar results. 
Keywords:  Commodity futures ; Seasonality ; Costofcarry ; Risk premium ; Nelson and Siegel JEL Classification Numbers: C22 ; G12 ; G13 ; 
Date:  2018 
URL:  http://d.repec.org/n?u=RePEc:wrk:wrkemf:18&r=upt 