
on Utility Models and Prospect Theory 
Issue of 2018‒04‒30
eighteen papers chosen by 
By:  Leites, Martin (Universidad de la República, Uruguay); Ramos, Xavier (Universitat Autònoma de Barcelona) 
Abstract:  Income comparisons are important for individual wellbeing. We examine the shape of the relationship between relative income and life satisfaction, and test empirically if the features of the value function of prospect theory carry on to experienced utility. We draw on a unique dataset for a middleincome country, that allows us to work with an endogenous reference income, which differs for individuals with the same observable characteristics, depending on the perception error about their relative position in the distribution. We find the value function for experienced utility to be concave for both positive and, at odds with prospect theory, also negative relative income. Loss aversion is only satisfied for incomes that are sufficiently distant from the reference income. Our heterogeneity analysis shows that the slope of the value function differs across individuals who care differently about income comparisons, people with different personality traits, or social beliefs. 
Keywords:  life satisfaction, relative income, loss aversion, prospect theory 
JEL:  D6 I31 
Date:  2018–03 
URL:  http://d.repec.org/n?u=RePEc:iza:izadps:dp11404&r=upt 
By:  Pivato, Marcus; Vergopoulos, Vassili 
Abstract:  In many decisions under uncertainty, there are technological constraints on the acts an agent can perform and on the events she can observe. To model this, we assume that the set S of possible states of the world and the set X of possible outcomes each have a topological structure. The only feasible acts are continuous functions from S to X, and the only observable events are regular open subsets of S. We axiomatically characterize Subjective Expected Utility (SEU) representations of conditional preferences over acts, involving a continuous utility function on X (unique up to positive affine transformations), and a unique Borel probability measure on S, along with an auxiliary apparatus called a "liminal structure", which describes the agent’s imperfect perception of events. We also give other SEU representations, which use residual probability charges or compactifications of the state space. 
Keywords:  Subjective expected utility; topological space; technological feasibility; continuous utility; regular open set; Borel measure 
JEL:  D81 
Date:  2018–04–08 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:85749&r=upt 
By:  Marco Nieddu (Università di Cagliari and CRENoS); Lorenzo Pandolfi (Università di Napoli Federico II and CSEF) 
Abstract:  We examine the impact of financial literacy on investors’ subjective valuation of financial assets. In a laboratory experiment, we study how the certainty equivalent of a risky lottery changes when varying the framing of the lottery – a financial asset vs. a coin toss – and participants’ level of financial literacy – via teaching basic financial notions. Enhancing financial literacy improves the understanding of the lottery’s structure and increases its certainty equivalent, thus offsetting the negative effects of the financial framing. Our results – which can be rationalized by ambiguity aversion – highlight the importance of promoting financial education to stimulate households’ financial market participation. 
Keywords:  financial literacy; experimental finance; financial market participation; ambiguity aversion. 
JEL:  D14 D81 G11 I22 
Date:  2018–04–22 
URL:  http://d.repec.org/n?u=RePEc:sef:csefwp:497&r=upt 
By:  Peter Bank; Moritz Vo{\ss} 
Abstract:  We introduce a price impact model which accounts for finite market depth, tightness and resilience. Its coupled bid and askprice dynamics induce convex liquidity costs. We provide existence of an optimal solution to the classical problem of maximizing expected utility from terminal liquidation wealth at a finite planning horizon. In the specific case when market uncertainty is generated by an arithmetic Brownian motion with drift and the investor exhibits constant absolute risk aversion, we show that the resulting singular optimal stochastic control problem readily reduces to a deterministic optimal tracking problem of the optimal frictionless constant Merton portfolio in the presence of convex costs. Rather than studying the associated HamiltonJacobiBellmann PDE, we exploit convex analytic and calculus of variations techniques allowing us to construct the solution explicitly and to describe the free boundaries of the action and nonaction regions in the underlying state space. As expected, it is optimal to trade towards the frictionless Merton position, taking into account the initial bidask spread as well as the optimal liquidation of the accrued position when approaching terminal time. It turns out that this leads to a surprisingly rich phenomenology of possible trajectories for the optimal share holdings. 
Date:  2018–04 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1804.07392&r=upt 
By:  Ludmila Matyskova 
Abstract:  A sender who chooses a signal to reveal to a receiver can often influence the receiver’s subsequent actions. Is persuasion more difficult when the receiver has her own sources of information? Does the receiver benefit from having additional information sources? We consider a Bayesian persuasion model extended to a receiver’s endogenous acquisition of information under an entropybased cost commonly used in rational inattention. A sender’s optimal signal can be computed from standard Bayesian persuasion subject to an additional constraint: the receiver never gathers her own costly information. We further determine a finite set of the sender’s signals satisfying the additional constraint in which some optimal signal must be contained. The set is characterized by linear conditions using the receiver’s utility and information cost parameters. The new method is also applicable to a standard Bayesian persuasion model and can simplify, sometimes dramatically, the search for a sender’s optimal signal (as opposed to a standard concavification technique used to solve these models). We show that the ‘threat’ of additional learning weakly decreases the sender’s expected equilibrium payoff. However, the outcome can be worse not only for the sender, but also for the receiver. 
Keywords:  Bayesian persuasion; rational inattention; costly information acquisition; information design; 
JEL:  D72 D81 D82 D83 
Date:  2018–03 
URL:  http://d.repec.org/n?u=RePEc:cer:papers:wp614&r=upt 
By:  Benchimol, Jonathan; Bounader, Lahcen 
Abstract:  Optimal monetary policy under discretion, commitment, and optimal simple rules regimes is analyzed through a behavioral New Keynesian model. Flexible price level targeting dominates under discretion; flexible inflation targeting dominates under commitment; and strict price level targeting dominates when using optimal simple rules. The optimality of a particular regime is found to be independent of bounded rationality and only regime 's stabilizing properties condition its hierarchy. For every targeting regime, the policymaker 's knowledge of agents' myopia is decisive in terms of policy reactions. Welfare evaluation of different targeting regimes reveals that bounded rationality is not necessarily associated with decreased welfare. Several forms of economic inattention can increase welfare. 
JEL:  C53 E37 E52 D01 D11 
Date:  2018–04–19 
URL:  http://d.repec.org/n?u=RePEc:bof:bofrdp:2018_009&r=upt 
By:  Simon Hoof (Paderborn University) 
Abstract:  This note deals with agreeability in nontransferable utility (NTU) differential games. We introduce state feedback Pareto weights to enrich the set of efficient cooperative solutions. The framework is particularly useful if constant weights fail to support agreeability, but cooperation is desired nonetheless. The concept is applied to an adverting differential game. 
Keywords:  NTU differential games, variable Pareto weights, agreeability 
JEL:  C02 C61 C71 
Date:  2018–02 
URL:  http://d.repec.org/n?u=RePEc:pdn:ciepap:112&r=upt 
By:  Vassilopoulos, Achilleas; Drichoutis, Andreas C.; Nayga, Rodolfo 
Abstract:  We present the results of an economic laboratory experiment that tests behavioral biases that have been associated with the BDM mechanism. By manipulating the highest random competing bid, the maximum possible loss, the distribution of prices and the elicitation format, we attempt to disentangle the effects of referencedependence, expectations as well as price and loss anchoring on subjects' bids. The results show that bids are affected by expectations and anchoring on the highest price but not by anchoring on the maximum possible loss. In addition, results are supportive of the nolossinbuying hypothesis of Novemsky and Kahneman (2005). 
Keywords:  BeckerDeGrootMarschak (BDM) mechanism; expectations; anchoring; valuation; experiment 
JEL:  C91 D44 
Date:  2018–03–22 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:85635&r=upt 
By:  Willem Van Laarhoven; Aloys Borgers; Pauline Van den Berg 
Abstract:  The main reason for this research was the bankruptcy of one the Dutch oldest and largest chain of department stores at the end of 2015. The main goal of this research is to find what, from a consumers’ perspective, a department store should look like. A four storey (1500 m2 each) building was assumed to be vacant in the shopping areas of the large and medium sized Dutch cities. In addition, it was assumed that each floor would accommodate only one department. The two main research questions were: 1) as department stores may offer more than four departments, which are the four most preferred departments, and 2) to which floor should each of the most preferred departments be allocated.This study measured consumers’ preferences by means of a survey among approximately 500 respondents. Six different departments were selected to be part of a department store: 1) Fashion, 2) Food, 3) Beauty, 4) Living, 5) Electronics, and 6) Active/outdoor. To familiarize the respondents with these departments, each respondent was asked to pick a number of subdepartments and services from a predefined list to fill each department. The floor area of each subdepartment and service was provided. The sum of the floor areas per department had to be within the 12501750 m2 range.To answer the first research question, a stated choice approach was used. Each respondent was presented a number of pairs of the 15 possible combinations of four out of six departments. The multinomial logit (MNL) model was used to estimate the utility of each department. The order of preference appeared to be: 1) Fashion, 2) Living, 3) Food, 4) Beauty, 5) Active/outdoor, and 6) Electronics for females and 1) Electronics, 2) Fashion, 3) Food, 4) Living, 5) Active/outdoor and 6) Beauty for males.The second research question was answered by having respondents allocating departments to floors of the building. Per respondent, this was repeated three times with three randomly picked combinations of 4 departments. Again, the MNL model was used to estimate the utility of each floor for each department. Building on the results for the most preferred combinations of departments, the preferred composition for females is Food at the ground floor, Fashion at the 1st floor, Living at the 2nd floor and Beauty at the 3rd floor. For males, the third floor should contain Electronics. 
Keywords:  Consumer preferences; Department Stores; Retail Research 
JEL:  R3 
Date:  2017–07–01 
URL:  http://d.repec.org/n?u=RePEc:arz:wpaper:eres2017_54&r=upt 
By:  Lars Vandrei 
Abstract:  A puzzling observation on housing markets is the strong positive correlation between prices and trade volume for rising prices. Yet, in a declining market suppliers hesitate to adjust prices to a smaller demand. The majority of literature addresses this issue using search and matching models. A behavioral approach as it is very common in the economic finance literature has only been considered briefly to explain price rigidities. This work provides a theoretical model in order to better understand incentives on the supply and demand side of the housing market.From a behavioral finance perspective and in particular the prospect theory, utility is determined by changes in wealth rather than absolute values. Prospect theory further suggests different attitudes towards risk for potential losses and potential profits. Thus, the price setting mechanism is influenced by a certain reference point, e. g. the originally paid price or the house's construction costs. Therefore, the market development dictates whether home owners accept purchase offers easily or are reluctant to sell. In particular, if the market faces a downturn and the market value of an object falls below the originally paid nominal price, sellers will be less averse towards risk. On the other hand, sellers might accept prices below the market value but above the originally paid price if the market developed favorably.The most pressing question is how prices are determined on the housing market. Following finance literature, the price evolution can be thought of as a stochastic process, i.e. a Brownian motion. This would suffice to explain different attitudes towards risk for homogeneous agents. However, according to the underlying value function in prospect theory, the buyer would not be willing to buy a house at market price for sheer investment purposes, since it is too risky. Therefore, in my model, the personal assessment of a houses value consists of two components: the investment value and the personal housing value.My model especially applies for the market for singlefamily homes, since this type of accommodation is typically owner occupied and makes up a large part of the housing stock in rural areas. Not only does the model help understand why households might be reluctant to sell even if the current housing situation is suboptimal in regard to e. g. household size. It does also suggest a higher ratio of vacant houses for markets which took a downturn. 
Keywords:  behavioral economics; price rigidities; prospect theory 
JEL:  R3 
Date:  2017–07–01 
URL:  http://d.repec.org/n?u=RePEc:arz:wpaper:eres2017_91&r=upt 
By:  Lin, YuHsuan 
Abstract:  This study examines the impact of social preferences on the individual incentives of participating in climate coalitions with laboratory experimental evidences. The theoretical result suggests that, when a player was inequalityneutral, a dominant strategy equilibrium could exist. However, individuals with social preference may lead a vacillated coalition formation. Joining or not joining depend on the player was critical or noncritical to an effective coalition respectively. The laboratory experimental result shows that players were inequalityaverse and the coalition was usually larger than the equilibrium size but unstable. The inequalityaverse attitudes have significantly positive impact on the incentives of participation. Particularly, when they are noncritical players, egalitarians are likely to give up the free riding benefit by joining a coalition. Our findings help to understand the climate coalition formation. 
Keywords:  international environmental agreements; social preference; inequalityaversion; experimental design; climate coalition 
JEL:  C91 D63 D71 Q54 Q58 
Date:  2018–03 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:85428&r=upt 
By:  Pierre Dehez; Victor Ginsburgh 
Abstract:  Approval voting allows voters to list any number of candidates. Their scores are obtained by summing the votes cast in their favor. Fractional voting instead follows the Onepersononevote principle by endowing voters with a single vote that they may freely distribute among candidates. In this paper, we show that to be fair, such a ranking requires a uniform distribution. It corresponds to Shapley ranking that was introduced to rank wines as the Shapley value of a cooperative game with transferable utility. We analyze the properties of these "ranking games" and provide an axiomatic foundation to Shapley ranking. We also analyze Shapley ranking as a social welfare function and compare it to approval ranking. 
Date:  2018–04 
URL:  http://d.repec.org/n?u=RePEc:eca:wpaper:2013/269405&r=upt 
By:  AugeraudVéron, E.; Fabbri, G.; Schubert, K. 
Abstract:  This paper presents a benchmark stochastic endogenous growth model of an agricultural economy. Producing food requires land, and increasing the share of total land devoted to farming mechanically reduces the share of land devoted to biodiversity conservation. However, safeguarding a greater number of species guarantees, through spatial exchanges, better ecosystem services which, in turn, ensure lower volatility of agricultural productivity. The optimal conversion/conservation rule is explicitly characterized, as well as the total value of biodiversity in terms of the welfare gain from biodiversity conservation, and the marginal value of biodiversity in terms of risk premium reduction, namely its insurance value. The EpsteinZinWeil specification of preferences allows us to disentangle the effects of risk aversion and aversion to fluctuations. 
Keywords:  BIODIVERSITY;STOCHASTIC ENDOGENOUS GROWTH;INSURANCE VALUE;RECURSIVE PREFERENCES 
JEL:  Q56 Q58 Q10 Q15 O13 O20 C73 
Date:  2018 
URL:  http://d.repec.org/n?u=RePEc:gbl:wpaper:201805&r=upt 
By:  Corsetti, Giancarlo; Dedola, Luca; Leduc, Sylvain 
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 marketsâ€“where inefficient capital flows and exchange rate misalignments can arise independently of nominal distortions. We derive a quadratic approximation of the utilitybased global policy loss function under fairly general assumptions on preferences and openness, and solve for the optimal targeting rules under co operation. 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:  asset markets and risk sharing; Currency misalignments; exchange rate passthrough; international policy cooperation; optimal targeting rules; trade imbalances 
JEL:  E44 E52 E61 F41 F42 
Date:  2018–04 
URL:  http://d.repec.org/n?u=RePEc:cpr:ceprdp:12850&r=upt 
By:  Larmande, François; Stolowy, Hervé 
Abstract:  This paper investigates the link between one managerial characteristic, the degree of risk aversion, and accounting conservatism. Two models are analyzed, one where the degree of conservatism is chosen by the principal (Board) and accounting information is used for stewardship, and a second where the principal delegates the choice of the degree of conservatism to the manager and accounting information is primarily used for investment efficiency. We show in the first model that higher risk aversion reduces the demand for conservatism from a stewardship point of view. In the second model, we show that delegation is an optimal way for the principal of committing to conservative reporting. Hiring a more riskaverse manager lowers the cost of implementing this conservative reporting. The two models provide opposite predictions for the association between managerial risk aversion and the degree of conservatism. Empirical evidence favors the second model’s prediction. The paper suggests that managers with specific characteristics and incentive contracts might be endogenously chosen by the firm to implement an exante optimal degree of conservatism. 
Keywords:  Accounting Conservatism; Risk Aversion; Limited Liability; Reporting Bias; PrincipalAgent Theory; Stewardship; Investment Efficiency 
JEL:  D82 D86 G30 M41 M51 M52 
Date:  2017–06–01 
URL:  http://d.repec.org/n?u=RePEc:ebg:heccah:1215&r=upt 
By:  Alla Koblyakova; Timothy Eccles 
Abstract:  The primary goal of this paper has been to address the question of rationality and subjectivity in mortgage contract choice decisions. These decisions are important because the size of a mortgage and the financial features of a mortgage contract are suggested to have important implications for both the household’s welfare and the stability of the financial system. Thus far, most of the existing literature has focused upon normative implications for rational mortgage choice decisions, providing only the one direction in generating both theoretical foundations and informing specifications in existing empirical studies. What is missing in the mortgage market literature is that the underlying forces leading to risky and uninformed financial choices may not be explained solely by supply and demand factors, but should account for subjectivity and irrationality within suboptimal mortgage choice decisions. This paper addresses these questions and explores whether, in addition to the supply and demand side factors, subjective considerations may partially explain observed/expost mortgage type decisions. This is achieved by employing a theoretical model comprising of a two reduced form equations applying three stage least squares and maximum likelihood estimation techniques. For the first time, crosssectional estimations utilise data extracted from the Understanding Society Survey Data for the newly originated mortgage contracts, covering the period from 2009 to 2014. This periodical frame covers the UK’s variable market share peak, which is also a period of changing mortgage lending conditions and introduction of financial literacy measures.Empirical results detect that subjective anticipation for the improvements in social status and expectations of better income increases likelihood of variable mortgage debt. Ability to take risks offers surprising results, suggesting that risk takers tend to prefer fixed rate mortgage options. The results also suggest that psychological reasons may explain why ARM borrowers tend to ignore the associated risk factors when choosing type of mortgage debt. The altering effect of time variation did not show significant results, empirically detecting persistent existence of the subjectivity in mortgage choice considerations. Policy implications may include development of training and financial literacy programs 
Keywords:  irrational behaviour; Mortgage Choice; risk taking; Subjectivity; suboptimal mortgage 
JEL:  R3 
Date:  2017–07–01 
URL:  http://d.repec.org/n?u=RePEc:arz:wpaper:eres2017_121&r=upt 
By:  Peter Dolton; George MacKerron 
Abstract:  Football is the national sport of most of the planet. This paper examines how happy the outcomes of football matches make us. We calibrate these results relative to other activities and estimate the dynamic effects these exogenous events have on our utility over time. We find that football – on average – makes us unhappier – so why would we go through the pain of following a football team. This behavioural choice paradox occupies much of the paper so we investigate why we go on following our teams, even though matches make us more unhappy on average. We examine how much our story changes if we examine the dynamic effects of football matches over time in different hours before and after the game and the extent to which our happiness is influenced by what we would rationally expect the result to be beforehand – as based on the betting odds. 
Keywords:  happiness, football, behavioural economics, irrationality, dynamic effects of outcomes, framed subjective utility 
JEL:  D23 D03 
Date:  2018–04 
URL:  http://d.repec.org/n?u=RePEc:nsr:niesrd:493&r=upt 
By:  Loeffler, Max (University of Cologne); Peichl, Andreas (Ifo Institute for Economic Research); Siegloch, Sebastian (University of Mannheim) 
Abstract:  There is still considerable dispute about the magnitude of labor supply elasticities. While differences in estimates especially between micro and macro models are recently attributed to frictions and adjustment costs, we show that the variation in elasticities derived from structural labor supply models can also be explained by modeling assumptions. Specifically, we estimate 3,456 different models on the same data each representing a plausible combination of frequently made choices. While many modeling assumptions do not systematically affect labor supply elasticities, our controlled metaanalysis shows that results are very sensitive to the treatment of hourly wages in the estimation. For example, different (sensible) choices concerning the modeling of the underlying wage distribution and especially the imputation of (missing) wages lead to point estimates of elasticities between 0.2 and 0.65. We hence conclude that researchers should pay more attention to the robustness of their estimations with respect to the wage treatment. 
Keywords:  labor supply, elasticity, random utility models, wages 
JEL:  C25 C52 H31 J22 
Date:  2018–03 
URL:  http://d.repec.org/n?u=RePEc:iza:izadps:dp11425&r=upt 