nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2018‒07‒23
twenty papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Mean-Variance Efficiency of Optimal Power and Logarithmic Utility Portfolios By Taras Bodnar; Dmytro Ivasiuk; Nestor Parolya; Wofgang Schmid
  2. The St. Petersburg Paradox Despite Risk-seeking Preferences: An Experimental Study By James C. Cox; Eike B. Kroll; Marcel Lichters; Vjollca Sadiraj; Bodo Vogt
  3. Portfolio Optimization with Nondominated Priors and Unbounded Parameters By Kerem Ugurlu
  4. Using multiple reference levels in Multi-Criteria Decision Aid: the Generalized-Additive Independence model and the Choquet integral approaches By Christophe Labreuche; Michel Grabisch
  5. EPIC: Welfare Maximization under Economically Postulated Independent Cascade Model By Prithu Banerjee; Wei Chen; Laks V. S. Lakshmanan
  6. A Not so Myopic Axiomatization of Discounting By Jean-Pierre Drugeon; Thai Ha-Huy
  7. Can organisational ambidexterity kill innovation? A case for non-expected utility decision making By Mario Le Glatin; Pascal Le Masson; Benoit Weil
  8. The Economic Relevancy of Risk Preferences Elicited Online and With Low Stakes By Gibson, John; Johnson, David
  9. Selective Sampling with Information-Storage Constraints By Philippe Jehiel; Jakub Steiner
  10. The Term Structure of Variance Swaps and Risk Premia By Yacine Ait-Sahalia; Mustafa Karaman; Loriano Mancini
  11. ICT, Leisure Externality and Wellbeing By Dibyendu Maiti
  12. Financialisation and the Term Structure of Commodity Risk Premiums By Jonathan Hambur; Nick Stenner
  13. The Origin and the Resolution of Nonuniqueness in Linear Rational Expectations By John G. Thistle
  14. Inclusive Cognitive Hierarchy in Collective Decisions By Yukio Koriyama; Ali Ozkes
  15. The generation gap in direct democracy By Ahlfeldt, Gabriel M.; Maennig, Wolfgang; Mueller, Steffen Q.
  16. Does promoting homeownership always damage labour market performances? By Julie Beugnot; Olivier Charlot; Guy Lacroix
  17. Attention and Selection Effects By Sandro Ambuehl; Axel Ockenfels; Colin Stewart
  18. Chance or Ability? The Efficiency of the Football Betting Market Revisited By Gross, Johannes; Rebeggiani, Luca
  19. How do people interpret macroeconomic shocks? Evidence from U.S. survey data By Martin Geiger; Johann Scharler
  20. Behavioral responses to subsidies in risky investment decisions and the effectiveness of tax credits and grants By Ackermann, Hagen; Fochmann, Martin; Temme, Rebecca

  1. By: Taras Bodnar; Dmytro Ivasiuk; Nestor Parolya; Wofgang Schmid
    Abstract: We derive new results related to the portfolio choice problem for a power and logarithmic utilities. Assuming that the portfolio returns follow a log-normal distribution, the closed-form expressions of the optimal portfolio weights are obtained for both utility functions. Moreover, we prove that both optimal portfolios belong to the set of mean-variance feasible portfolios and establish necessary and sufficient conditions such that they are mean-variance efficient. Furthermore, an application to the stock market is presented and the behavior of the optimal portfolio is discussed for different values of the relative risk aversion coefficient. It turns out that the assumption of log-normality does not seem to be a strong restriction.
    Date: 2018–06
  2. By: James C. Cox; Eike B. Kroll; Marcel Lichters; Vjollca Sadiraj; Bodo Vogt
    Abstract: The St. Petersburg Paradox is one of the oldest challenges of expected value theory. Thus far, explanations of the paradox aim at small probabilities being perceived as zero and the boundedness of utility of the outcome. This paper provides experimental results showing that neither diminishing marginal utility of the outcome nor perception of small probabilities can explain the paradox. We find that even in situations where subjects are risk-seeking, and zeroing-out small probabilities supports risktaking, the St. Petersburg Paradox exists. This indicates that the paradox cannot be resolved by the arguments advanced to date.
    Keywords: expected utility, risk preferences, gains, losses, St. Petersburg
    JEL: C91 D81
    Date: 2018–07
  3. By: Kerem Ugurlu
    Abstract: We consider classical Merton problem of terminal wealth maximization in finite horizon. We assume that the drift of the stock is following Ornstein-Uhlenbeck process and the volatility of it is following GARCH(1) process. In particular, both mean and volatility are unbounded. We assume that there is Knightian uncertainty on the parameters of both mean and volatility. We take that the investor has logarithmic utility function, and solve the corresponding utility maximization problem explicitly. To the best of our knowledge, this is the first work on utility maximization with unbounded mean and volatility in Knightian uncertainty under nondominated priors.
    Date: 2018–07
  4. By: Christophe Labreuche (Thales Research and Technology [Palaiseau] - THALES); Michel Grabisch (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, PSE - Paris School of Economics)
    Abstract: In many Multi-Criteria Decision problems, one can construct with the decision maker several reference levels on the attributes such that some decision strategies are conditional on the comparison with these reference levels. The classical models (such as the Choquet integral) cannot represent these preferences. We are then interested in two models. The first one is the Choquet with respect to a p-ary capacity combined with utility functions, where the p-ary capacity is obtained from the reference levels. The second one is a specialization of the Generalized-Additive Independence (GAI) model, which is discretized to fit with the presence of reference levels. These two models share common properties (monotonicity, continuity, properly weighted, …), but differ on the interpolation means (Lovász extension for the Choquet integral, and multi-linear extension for the GAI model). A drawback of the use of the Choquet integral with respect to a p-ary capacity is that it cannot satisfy decision strategies in each domain bounded by two successive reference levels that are completely independent of one another. We show that this is not the case with the GAI model.
    Abstract: Dans beaucoup de problème de décision multicritère, on peut construire avec le décideur plusieurs niveaux de référence sur les attributs de telle sorte que des stratégies de décision soient conditionnelles sur la comparaison avec les niveaux de référence. Les modèles classiques (Choquet) ne peuvent représenter ces préférences. Nous nous intéressons à deux modèles, le premier étant Choquet vs. une p-capacité qui est obtenue à partir des niveaux de référence. Le second est une spécialisation du modèle GAI (Generalized-Additive Independence). Ces deux modèles ont en commun des propriétés (monotonie, continuité), mais diffèrent sur le type d'interpolation (Lovász, multilinéaire). Un défaut de l'intégrale de Choquet est qu'elle ne satisfait pas les stratégies de décision dans chaque domaine borné par deux niveaux de références indépendants l'un de l'autre. Nous montrons que cela ne peut arriver avec le modèle GAI.
    Keywords: multiple criteria analysis,Generalized Additive Independence,Choquet integral,reference levels,intégrale de Choquet,niveau de références,interpolation,GAI,analyse multicritère
    Date: 2018–03
  5. By: Prithu Banerjee; Wei Chen; Laks V. S. Lakshmanan
    Abstract: In economics, it is well accepted that adoption of items is governed by the utility that a user derives from their adoption. In this paper, we propose a model called EPIC that combines utility-driven item adoption with the viral network effect helping to propagate adoption of and desire for items from users to their peers. We focus on the case of mutually complementary items and model their adoption behavior via supermodular value functions. We assume price is additive and use zero mean random noise to capture the uncertainty in our knowledge of user valuations. In this setting, we study a novel problem of \emph{social welfare maximization}: given item budgets, find an optimal allocation of items to seed nodes that maximizes the sum of expected utilities derived by users when the diffusion terminates. We show the expected social welfare is monotone but neither submodular nor supermodular. Nevertheless, we show that a simple greedy allocation can ensure a $(1-1/e-\epsilon)$-approximation to the optimum. To the best of our knowledge, this is the first instance where for a non-submodular objective in the context of viral marketing, such a high approximation ratio is achieved. We provide the analysis of this result, which is highly nontrivial and along the way we give a solution to the prefix-preserving influence maximization problem, which could be of independent interest. With extensive experiments on real and synthetic datasets, we show that our algorithm significantly outperforms all the baselines.
    Date: 2018–07
  6. By: Jean-Pierre Drugeon (PSE - Paris School of Economics, PJSE - Paris Jourdan Sciences Economiques - UP1 - Université Panthéon-Sorbonne - ENS Paris - École normale supérieure - Paris - INRA - Institut National de la Recherche Agronomique - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique); Thai Ha-Huy (EPEE - Centre d'Etudes des Politiques Economiques - UEVE - Université d'Évry-Val-d'Essonne)
    Abstract: This article builds an axiomatization of inter-temporal trade-offs that makes an explicit account of the distant future and therefore encompasses motives related to sustainability, transmission to offsprings and altruism. The focus is on separable representations and the approach is completed following a decision-theory index based approach that is applied to utility streams. This enlightens the limits of the commonly used tail intensity requesites for the evaluation of utility streams: in this article, these are supersed and replaced by an axiomatic approach to optimal myopia degrees that in its turn precedes the determination of optimal discount. The overall approach is anchored in the new and explicit proof of a temporal decomposition of the preference orders between the distant future and the close future itself directly related to the determination of the optimal myopia degrees. The argument is shown to provide a novel understanding of temporal biases with the scope for a distant future bias when the finite dimensional gets influenced by the infinite dimensional. The reference to robust orders and pessimism-like axioms finally allows for determining tractable representations for the indexes.
    Abstract: JEL Codes: D11, D15, D90.
    Keywords: Discount,Temporal Order Decompositions,Infinite Dimensional Topologies,Axiomatization,Myopia
    Date: 2018–04
  7. By: Mario Le Glatin (CGS i3 - Centre de Gestion Scientifique i3 - MINES ParisTech - École nationale supérieure des mines de Paris - PSL - PSL Research University - CNRS - Centre National de la Recherche Scientifique); Pascal Le Masson (CGS i3 - Centre de Gestion Scientifique i3 - MINES ParisTech - École nationale supérieure des mines de Paris - PSL - PSL Research University - CNRS - Centre National de la Recherche Scientifique); Benoit Weil (CGS i3 - Centre de Gestion Scientifique i3 - MINES ParisTech - École nationale supérieure des mines de Paris - PSL - PSL Research University - CNRS - Centre National de la Recherche Scientifique)
    Abstract: The academic construction of ambidexterity articulated around notions such as exploration, exploitation (J. March 1991) has been flourishing over the years with a strong background in organisational theory to explain levels of performance and innovation. However, they have also made a call for in-depth studies to understand managerial capabilities such as decision-making (Birkinshaw & Gupta 2013; O'Reilly & Tushman 2013; Benner & Tushman 2015) supporting the tension of competing objectives. In this paper, we show that organisational ambidexterity can kill innovation as the underlying decision theories are not fully supporting the nature of decision required in regimes such as contextual ambidexterity (Gibson & Birkinshaw 2004). Two case studies from the aircraft cabin equipment industry are presented and analysed at the project management level with descriptors from organisational ambidexterity and decision-making. We propose to consider unconventional decision theories, taking into account non-expected utilities such as potential regret of imagined prospects, as a means to support management tools enabling ambidexterity at the decisional and contextual levels. First, we show that common decision models based on expected utility encoded in management tools mobilised for contextual ambidexterity can fail to support innovation. Second, we propose that a non-expected utility, such as potential regret of imagined prospects, serves the management of competing exploration/exploitation objectives. Third, the case studies help contouring a management tool extending observed attempts to sustain or extend contextual ambidexterity through unconventional decision-making.
    Keywords: decision,project management,design,ambidexterity,management tool
    Date: 2018–06–19
  8. By: Gibson, John; Johnson, David
    Abstract: We explore the relevancy of subjects' risk preferences recovered using a subjective risk question to those recovered from the incentivized lottery experiments of Holt and Laury (2002), Gneezy and Potters (1997), and Johnson and Webb (2016). While a statistically significant relationship between subjective and incentivized risk measures has been documented, existing papers utilize laboratory (or lab-in-field) experiments with moderately large stakes. We investigate whether this relationship is preserved in an online environment with small stakes. Our results are consistent with the previous literature, suggesting that the correlation between subjective and incentivized risk measures is preserved online and with small stakes.
    Keywords: Subjective Risk Preferences; Incentivized Risk Measures; Online Experiments
    JEL: C90 D01 D03
    Date: 2018–06–08
  9. By: Philippe Jehiel; Jakub Steiner
    Abstract: A decision-maker acquires payoff-relevant information until she reaches her storing capacity, at which point she either terminates the decision-making and chooses an action, or discards some information. By conditioning the probability of termination on the information collected, she controls the correlation between the payoff state and her terminal action. We provide an optimality condition for the emerging stochastic choice. The condition highlights the benefits of selective memory applied to the extracted signals. The constrained-optimal choice rule exhibits (i) confirmation bias, (ii) speed-accuracy complementarity, (iii) overweighting of rare events, and (iv) salience effect.
    Keywords: bounded rationality; cognitive constraints; information processing; stochastic choice; confirmation bias; speed-accuracy complementarity; probability weighting; salience;
    JEL: D03 D80 D81 D83 D89 D90
    Date: 2018–07
  10. By: Yacine Ait-Sahalia (Princeton University and National Bureau of Economic Research (NBER)); Mustafa Karaman (University of Zurich); Loriano Mancini (University of Lugano and Swiss Finance Institute)
    Abstract: We study the term structure of variance swaps, equity and variance risk premia. A model-free analysis reveals a significant price jump component in variance swap rates. A model-based analysis shows that investors' willingness to ensure against volatility risk increases after a market drop. This effect is stronger for short horizons and more persistent for long horizons. During the financial crisis investors demanded large risk premia to hold equities but the risk premia largely depended and strongly decreased with the holding horizon. The term structure of equity and variance risk premia responds differently to various economic indicators.
    Keywords: Variance Swap, Stochastic Volatility, Likelihood Approximation, Term Structure, Equity Risk Premium, Variance Risk Premium
    JEL: C51 G12 G13
    Date: 2018–05
  11. By: Dibyendu Maiti (Department of Economics, Delhi School of Economics)
    Abstract: ICTs that offers various goods and services to be used specially during the leisure time create two types of favourable ‘leisure externality’ - on direct utility and income through the formation of knowledge and social capital required productivity improvement. The paper builds a two-sector static model with consumption and leisure goods to capture such leisure externalities endogenously. Raising marginal benefits of leisure, one externality increases the demand for labour to meet additional production for ICT goods and consumption goods. This apart, the other externality raises productivity through knowledge formation, which could bind the labour demand. In effect, both income and utility tend to rise in presence both externalities, but it does not necessarily reduce the gap between them (known as Eastelin paradox) and depends upon their relative strengths .
    Keywords: ICT, Leisure Externality, Two-sector model, Income-utility gap
    JEL: I31 J22 O41
    Date: 2018–04
  12. By: Jonathan Hambur (Reserve Bank of Australia); Nick Stenner (Reserve Bank of Australia)
    Abstract: Commodities, such as oil and wheat, are important inputs into the real economy. They have a significant influence on the welfare of individuals through their role as consumption goods and as inputs into other goods. As such, it is important to understand how commodity prices are set and whether there are any distortions to these prices. One component of commodity futures prices is the risk premium, which reflects the return investors demand to take on producers' and consumers' natural exposures to commodity prices. Therefore, to better understand the determination of commodity futures prices this paper examines commodity risk premiums and their determinants. We find evidence that commodity risk premiums vary across futures contract maturities, and that the shape of the commodity risk premium 'curve' differs across commodities and over time. This suggests information could be contained in the shape of the risk premium curve. We also find strong evidence of a relationship between the net of producers' (short) and consumers' (long) hedging positions – the net hedging position – and risk premiums, as would be suggested by the net hedging pressure theory. The evidence is generally more significant for longer-dated futures contracts. In addition, we consider whether the large increase in the size of commodity-related financial markets over the 2000s – commodity market financialisation – has affected commodity risk premiums. We find little statistical evidence that financialisation has had a significant effect on the 'residual' or idiosyncratic portion of commodity risk premiums for a broad basket of commodities. But we do find some evidence of smaller residual risk premiums for wheat, particularly for short-maturity contracts. This could reflect either decreased market segmentation or a secular increase in demand for long positions. We also find evidence that financialisation increased the systematic portion of commodity risk premiums by increasing the correlation between returns on commodity futures and returns on the 'market' portfolio. This was more evident for longer-maturity contracts of 6–18 months.
    Keywords: commodity prices; financial markets
    JEL: G13 Q02
    Date: 2017–05
  13. By: John G. Thistle
    Abstract: The nonuniqueness of solutions of linear rational-expectations models is explained and resolved. In the stochastic, discrete-time, constant-coefficients case, the associated free parameters are shown to be the initial values of the impulse responses of expectation terms. These values may be completely unconstrained by the requirement of model-consistency, yet when appropriately specified, they determine a unique solution for a broad class of models. This finding demonstrates the necessity of complementing rational expectations with models of the most immediate forecast revisions that result from economic shocks.
    Date: 2018–06
  14. By: Yukio Koriyama (Department of Economics, Ecole Polytechnique - X - École polytechnique - CNRS - Centre National de la Recherche Scientifique); Ali Ozkes (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - ECM - Ecole Centrale de Marseille - CNRS - Centre National de la Recherche Scientifique - AMU - Aix Marseille Université - EHESS - École des hautes études en sciences sociales)
    Abstract: We study the implications of structural models of non-equilibrium thinking, in which players best respond while holding heterogeneous beliefs on the cognitive levels of others. We introduce an inclusive cognitive hierarchy model, in which players are capable of projecting the self to others in regard to their cognitive level. The model is tested in a laboratory experiment of collective decision-making, which supports inclusiveness. Our theoretical results show that inclusiveness is a key factor for asymptotic properties of deviations from equilibrium behavior. Asymptotic behavior can be categorized into three distinct types: naïve, Savage rational with inconsistent beliefs, and sophisticated.
    Keywords: collective decision-making,bounded rationality,cognitive hierarchy,information aggregation
    Date: 2018–06
  15. By: Ahlfeldt, Gabriel M.; Maennig, Wolfgang; Mueller, Steffen Q.
    Abstract: We provide the first systematic documentation and analysis of a generation gap in direct democracy outcomes across a wide range of topics using postelection survey data covering more than 300 Swiss referenda and four decades. We find that older voters are more likely to resist reform projects, particularly those that are associated with the political left. We separate age and cohort effects without imposing functional form constraints using a panel rank regression approach. The aging effect on political orientation is robust for controlling for arbitrary cohort effects and appears to be driven by expected utility maximization and not by habituation-induced status-quo bias. Our results suggest that population aging raises the hurdle for investment-like reform projects with positive net present values, long-run benefits and short-run costs in direct polls.
    Keywords: age; cohort; direct democracy; generation gap; status quo; referendum; reform; utility
    JEL: D7 H3
    Date: 2018–06–01
  16. By: Julie Beugnot; Olivier Charlot; Guy Lacroix
    Abstract: In this paper we analyse the link between homeownership and various aggregate and individual labour market outcomes. Our aim is to investigate the likely consequences of public policies that promote homeownership. To this end, we develop a circular firm-worker matching model with Nash-bargained wage setting and free market entry. Homeowners are assumed to be less mobile than tenants and to bear higher mobility costs. Our numerical exercises show that tenants usually have lower unemployment rates and lower wage rates than homeowners. Importantly, workers’ performances do not necessarily improve following an increase in the proportion of homeowners. The latter crucially depends on the relative utility enjoyed by homeowners and tenants when unemployed. In the aggregate, nevertheless, we find that the unemployment rate generally increases following an increase in the proportion of homeowners. Yet, the link between the two can be reversed if the homeowners’ utility is lower than that of tenants when unemployed. Our model thus identifies a number of conditions under which Oswald’s conjecture is likely to hold or not. Thus, our results do not necessarily support the view that policies fostering homeownership are adequate public policies given their potentially negative effect on the labour market.
    Keywords: Stochastic job matching, Homeownership, Unemployment, Mobility
    JEL: H31 J61 J64 R23
    Date: 2018
  17. By: Sandro Ambuehl; Axel Ockenfels; Colin Stewart
    Abstract: Who participates in transactions when information about the consequences must be learned? We show theoretically that decision makers for whom acquiring and processing information is more costly respond more strongly to changes in incentive payments for participating and decide to participate based on worse information. With higher payments, the pool of participants thus consists of a larger proportion of individuals who have a worse understanding of the consequences of their decision. We conduct a behavioral experiment that confirms these predictions, both for experimental variation in the costs of information acquisition and for various measures of information costs, including school grades and cognitive ability. These findings are relevant for any transaction combining a payment for participation with uncertain yet learnable consequences.
    Keywords: rational inattention, incentives, selection effects, cognitive ability, experiment, repugnant transactions
    JEL: D01
    Date: 2018
  18. By: Gross, Johannes; Rebeggiani, Luca
    Abstract: The extent of market efficiency induced by rational behaviour of market participants is central for economic research. Many economists have already examined sports-betting markets as a laboratory to better understand trading behaviour and efficiency of stock prices while avoiding to jointly test the hypothesis of a correct capital market model. The following paper will investigate whether the European football betting market fulfils the efficiency paradigm introduced by Fama (1970) with a unique dataset allowing for an investigation of the German betting market in view of its regulatory changes recently. The analysis contributes to the literature by conducting a variety of empirical strategy including rational expectation frameworks and an ordered choice model to stress the ex post market performance from a weak and semi-strong form perspective. In view of existing market distortions as taxes, switching costs of changing betting providers and limitation in competition, the results of the analysis are indicative of a rational market equilibrium surprisingly close to the efficiency benchmark.
    Keywords: Sports Betting; Gambling; Market Efficiency; Sports Economics; Market Regulation
    JEL: G14 L83
    Date: 2018–06
  19. By: Martin Geiger; Johann Scharler
    Abstract: We study the revision of survey expectations in response to macroeconomic shocks, which we identify in vector autoregressive models with sign restrictions. We find that survey respondents distinguish between movements along the Phillips curve and shifts of the Phillips curve, depending on the type of the shock that hits the economy. In addition, expectations about future interest rate dynamics are revised broadly in line with a Taylor rule. While the macroeconomic shocks account only for a small share of the forecast error variance of survey measures elicited from consumers, they are more relevant for the expectations of professional forecasters. This result is consistent with models of rational inattention.
    Keywords: Macroeconomic Expectations, Michigan Survey, Structural Vector Autoregression, Zero and Sign Restrictions
    JEL: E00 E32 D84
    Date: 2018–07
  20. By: Ackermann, Hagen; Fochmann, Martin; Temme, Rebecca
    Abstract: We provide evidence that subsidy types that are identical in monetary terms differ in their behavioral responses and consequently in their effectiveness. In particular, we observe that investments into a subsidized asset are higher under tax credit than under grant. Both subsidy types are essentially very similar, only the mechanism of the subsidy application is different. In case of a grant, an individual gains an amount of money. In case of a tax credit, no money is received directly, but the tax to be paid is decreased by the amount of the tax credit. Our results indicate that these mechanisms have a substantial impact on the effectiveness of subsidies. Applying our findings, governments can "nudge" the investors to support desired investment decisions by using a certain subsidy type. Particularly, our results suggest that when policymakers are indifferent froma budget perspective between providing a subsidy as a grant or as a tax credit, they should implement a tax credit.
    Keywords: behavioral taxation,subsidy,risk-taking behavior,prospect theory
    JEL: C91 D14 H24
    Date: 2018

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