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on Utility Models and Prospect Theory |
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Issue of 2018‒09‒10
twenty-one papers chosen by |
| By: | Wei Ma (Department of Economics, University of Pretoria, Pretoria, South Africa) |
| Abstract: | This note generalizes Gul and Pesendorfer’s random expected utility theory, a stochastic reformulation of von Neumann-Morgenstern expected utility theory for lotteries over a finite set of prizes, to the circumstances with a continuum of prizes. Let [0;M] denote this continuum of prizes; assume that each utility function is continuous, let C0[0;M] be the set of all utility functions which vanish at the origin, and define a random utility function to be a finitely additive probability measure on C0[0;M] (associated with an appropriate algebra). It is shown here that a random choice rule is mixture continuous, monotone, linear, and extreme if, and only if, the random choice rule maximizes some regular random utility function. To obtain countable additivity of the random utility function, we further restrict our consideration to those utility functions that are continuously differentiable on [0;M] and vanish at zero. With this restriction, it is shown that a random choice rule is continuous, monotone, linear, and extreme if, and only if, it maximizes some regular, countably additive random utility function. This generalization enables us to make a discussion of risk aversion in the framework of random expected utility theory. |
| Date: | 2018–08 |
| URL: | http://d.repec.org/n?u=RePEc:pre:wpaper:201854&r=upt |
| By: | Martín Leites (University of la República, Uruguay); Xavier Ramos (Universitat Autònoma de Barcelona, Spain) |
| Abstract: | Income comparisons are important for individual well-being. 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 middle-income 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:inq:inqwps:ecineq2018-461&r=upt |
| By: | Freudenreich, Hanna; Musshoff, Oliver; Wiercinski, Ben |
| Abstract: | A farmer’s uncertainty preferences can play a large role in how he makes production decisions on the farm. We attempt to understand how farmers’ household characteristics as well as past harvest shocks affect uncertainty preferences of maize farmers in southern Mexico. By using a series of incentivized lottery games, we estimate coefficients that correspond to Cumulative Prospect Theory, namely the probability weighting function, the curvature of the value function and loss aversion, along with a coefficient for ambiguity aversion. These are estimated controlling for survey data of sociodemographic characteristics as well as maize harvest losses incurred between 2012-2014. Our results provide evidence that having experienced more severe harvest losses leads to more risk aversion and stronger overweighting of small probabilities. Higher losses are not related to loss aversion or ambiguity aversion. |
| Keywords: | Community/Rural/Urban Development, Farm Management, Risk and Uncertainty |
| Date: | 2017–03–01 |
| URL: | http://d.repec.org/n?u=RePEc:ags:gagfdp:256212&r=upt |
| By: | Lidia Ceriani (Georgetown University, USA); Paolo Verme (The World Bank, USA) |
| Abstract: | Despite the growing numbers of forcibly displaced persons worldwide, many people living under conflict choose not to flee. Individuals face two lotteries - staying or leaving- characterized by two distributions of potential outcomes. This paper proposes to model the choice between these two lotteries using quantile maximization as opposed to expected utility theory. We posit that risk-averse individuals aim at minimizing losses by choosing the lottery with the best outcome at the lower end of the distribution, whereas risk-tolerant individuals aim at maximizing gains by choosing the lottery with the best outcome at the higher end of the distribution. Using a rich set of household and conflict panel data from Nigeria, we find risk-tolerant individuals to have a significant preference for staying and risk-averse individuals to have a significant preference for fleeing in line with the predictions of the quantile maximization model. This is contrary to findings on economic migrants and calls for separate policies towards economic and forced migrants. |
| Keywords: | Conflict, migration, expected utility, forced displacement, quantile maximization. |
| JEL: | D01 D1 D3 D6 D7 D8 I3 |
| Date: | 2018–03 |
| URL: | http://d.repec.org/n?u=RePEc:inq:inqwps:ecineq2018-460&r=upt |
| By: | David Dillenberger (Department of Economics, University of Pennsylvania); Colin Raymond (Department of Economics, Amherst University) |
| Abstract: | Individuals often tend to conform to the choices of others in group decisions, compared to choices made in isolation, giving rise to phenomena such as group polarization and the bandwagon effect. We show that this behavior, which we term the consensus effect, is equivalent to a well-known violation of expected utility, namely strict quasi-convexity of preferences. In contrast to the equilibrium outcome when individuals are expected utility maximizers, quasi-convexity of preferences imply that group decisions may fail to properly aggregate preferences and strictly Pareto-dominated equilibria may arise. Moreover, these problems become more severe as the size of the group grows. |
| Keywords: | Aggregation of Preferences, Choice Shifts in Groups, Consensus Effect, Non-Expected Utility, Quasi-Convex Preferences |
| JEL: | D71 D81 |
| Date: | 2016–09–30 |
| URL: | http://d.repec.org/n?u=RePEc:pen:papers:16-015&r=upt |
| By: | Jetlir Duraj |
| Abstract: | News utility is the idea that the utility of an agent depends on changes in her beliefs over consumption and money. We introduce news utility into otherwise classical static Bayesian mechanism design models. We show that a key role is played by the timeline of the mechanism, i.e. whether there are delays between the announcement stage, the participation stage, the play stage and the realization stage of a mechanism. Depending on the timing, agents with news utility can experience two additional news utility effects: a surprise effect derived from comparing to pre-mechanism beliefs, as well as a realization effect derived from comparing post-play beliefs with the actual outcome of the mechanism. We look at two distinct mechanism design settings reflecting the two main strands of the classical literature. In the first model, a monopolist screens an agent according to the magnitude of her loss aversion. In the second model, we consider a general multi-agent Bayesian mechanism design setting where the uncertainty of each player stems from not knowing the intrinsic types of the other agents. We give applications to auctions and public good provision which illustrate how news utility changes classical results. For both models we characterize the optimal design of the timeline. A timeline featuring no delay between participation and play but a delay in realization is never optimal in either model. In the screening model the optimal timeline is one without delays. In auction settings, under fairly natural assumptions the optimal timeline has delays between all three stages of the mechanism. |
| Date: | 2018–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1808.04020&r=upt |
| By: | Annie Liang (Department of Economics, University of Pennsylvania) |
| Abstract: | Suppose that an analyst observes inconsistent choices from a decision maker. Can the analyst determine whether this inconsistency arises from choice error (imperfect maximization of a single preference) or from preference heterogeneity (deliberate maximization of multiple preferences)? I model choice data as generated from context-dependent preferences, where contexts vary across observations, and the decision maker errs with small probability in each observation. I show that (a) simultaneously minimizing the number of inferred preferences and the number of unexplained observations can exactly recover the correct number of preferences with high probability; (b) simultaneously minimizing the richness of the set of preferences and the number of unexplained observations can exactly recover the choice implications of the decision maker's true preferences with high probability. These results illustrate that selection of simple models, appropriately defined, is a useful approach for recovery of stable features of preference. |
| Date: | 2016–10–04 |
| URL: | http://d.repec.org/n?u=RePEc:pen:papers:16-029&r=upt |
| By: | Jan Christoph Schlegel |
| Abstract: | We establish the lattice theorem, rural hospitals theorem, and a group-incentive-compatibility result for terminal buyers (sellers) with unit demand, in a general bilateral trading network without making the assumption of quasi-linear utility in transfers. |
| Date: | 2018–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1808.07924&r=upt |
| By: | Rodwell Kufakunesu; Calisto Guambe; Lesedi Mabitsela |
| Abstract: | In this paper, we consider a risk-based optimal investment problem of an insurer in a regime-switching jump diffusion model with noisy memory. Using the model uncertainty modeling, we formulate the investment problem as a zero-sum, stochastic differential delay game between the insurer and the market, with a convex risk measure of the terminal surplus and the Brownian delay surplus over a period $[T-\varrho,T]$. Then, by the BSDE approach, the game problem is solved. Finally, we derive analytical solutions of the game problem, for a particular case of a quadratic penalty function and a numerical example is considered. |
| Date: | 2018–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1808.04604&r=upt |
| By: | Usher, Dan |
| Abstract: | Utilitarianism can be misplaced or ambiguous. As a prescription for individual behaviour, the injunction to seek the greatest good for the greatest number is misplaced because there remains a domain of life where, within the bounds of law and custom, one is free to act as selfishly or as altruistically as one pleases. As a criterion for responsible government, it is ambiguous because there is no universally-recognized perception of the greatest good; people have different perceptions which can only be reconciled by compromise or by voting. The greatest number must be of citizens alive today, but governments may be vicariously concerned about people in other countries or yet to be born, in so far as citizens today have such concerns and are prepared to sacrifice for the benefit of others. The greatest good for the greatest number has no rival as a criterion for government, but it is vague nonetheless. Utilitarian ambiguity is inherited in any attempt to combine the ordinary measure of economic growth with changes in the distribution of income on a common scale. |
| Keywords: | Financial Economics, Public Economics |
| Date: | 2017–07 |
| URL: | http://d.repec.org/n?u=RePEc:ags:quedwp:274711&r=upt |
| By: | Vittorio Bil\`o; Ioannis Caragiannis; Michele Flammini; Ayumi Igarashi; Gianpiero Monaco; Dominik Peters; Cosimo Vinci; William S. Zwicker |
| Abstract: | We study the existence of allocations of indivisible goods that are envy-free up to one good (EF1), under the additional constraint that each bundle needs to be connected in an underlying item graph G. When the items are arranged in a path, we show that EF1 allocations are guaranteed to exist for arbitrary monotonic utility functions over bundles, provided that either there are at most four agents, or there are any number of agents but they all have identical utility functions. Our existence proofs are based on classical arguments from the divisible cake-cutting setting, and involve discrete analogues of cut-and-choose, of Stromquist's moving-knife protocol, and of the Su-Simmons argument based on Sperner's lemma. Sperner's lemma can also be used to show that on a path, an EF2 allocation exists for any number of agents. Except for the results using Sperner's lemma, all of our procedures can be implemented by efficient algorithms. Our positive results for paths imply the existence of connected EF1 or EF2 allocations whenever G is traceable, i.e., contains a Hamiltonian path. For the case of two agents, we completely characterize the class of graphs $G$ that guarantee the existence of EF1 allocations as the class of graphs whose biconnected components are arranged in a path. This class is strictly larger than the class of traceable graphs; one can be check in linear time whether a graph belongs to this class, and if so return an EF1 allocation. |
| Date: | 2018–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1808.09406&r=upt |
| By: | John Creedy (Victoria University of Wellington, New Zealand); Norman Gemmell (Victoria University of Wellington, New Zealand); Nicolas Hérault (Melbourne Institute of Applied Economic and Social Research, Australia); Penny Mok (Ministry of Business, Innovation and Employment, New Zealand) |
| Abstract: | This paper examines the optimal direction of marginal income tax reform in the context of New Zealand, which recently reduced its top marginal income tax rate to one of the lowest in the OECD. A behavioural microsimulation model is used, in which social welfare functions are defined in terms of either money metric utility or net income. The model allows for labour supply responses to tax changes, in which a high degree of population heterogeneity is represented along with all the details of the highly complex income tax and transfer system. The implications of the results for specific combinations of tax rate or threshold changes, that are both revenue neutral and welfare improving, are explored in detail, recognising the role of distributional value judgements in determining an optimal reform.The potential impact of additional income responses is also examined, using the concept of the elasticity of taxable income. Results suggest, under a wide range of parameter values and assumptions, that raising the highest income tax rate and/or threshold, would be part of an optimal reform package. |
| Keywords: | Optimal taxation, tax reform, behavioural microsimulation, social welfare function, money metric utility. |
| JEL: | D63 H21 H31 I31 J22 |
| Date: | 2018–05 |
| URL: | http://d.repec.org/n?u=RePEc:inq:inqwps:ecineq2018-468&r=upt |
| By: | Rodwell Kufakunesu; Calisto Guambe |
| Abstract: | The aim of this paper is to solve an optimal investment, consumption and life insurance problem when the investor is restricted to capital guarantee. We consider an incomplete market described by a jump-diffusion model with stochastic volatility. Using the martingale approach, we prove the existence of the optimal strategy and the optimal martingale measure and we obtain the explicit solutions for the power utility functions. |
| Date: | 2018–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1808.04613&r=upt |
| By: | Gschwandtner, Adelina; Burton, Michael |
| Abstract: | There has been almost no recent formal economic analysis of the WTP of British consumers for organic products.1 Given the rising demand for organic products on one hand and the decline in the organically farmed area in the UK on the other hand, this is an important topic to address. The present paper analyses the demand for organic products using both stated and revealed preferences from the same consumers. The stated preference model is based on the respondent’s choice from hypothetical choice sets. Attributes in the stated preference model are based on the ranges of the actual levels of attributes found in shops and are presented to respondents using a fractional factorial statistical design. Three different hypothetical bias treatments are applied in order to reduce hypothetical bias. The stated preference results are validated with the help of actual consumption data from the weekly shopping of the same consumers. The results show that there exists a core of organic consumers of about 20-30% of the sample that have a positive willingness to pay for the organic label. However, consumers seem to be willing to pay more for other attributes such as a higher quality, environmentally friendly production and no chemical usage. Attributes such as animal welfare, and a longer expiry date do not seem to have the same relevance for the UK consumers. |
| Keywords: | Consumer/Household Economics, Demand and Price Analysis, Marketing |
| Date: | 2017–04–25 |
| URL: | http://d.repec.org/n?u=RePEc:ags:aesc17:258644&r=upt |
| By: | Christian Heyerdahl-Larsen (London Business School); Philipp Illeditsch (Carnegie Mellon University, Tepper Schoo) |
| Abstract: | Classical asset pricing models fail to account for the low correlation between macroeconomic fundamentals and (i) stock market returns and (ii) trading volume observed in the data. We develop an overlapping generations model with log utility investors who have heterogeneous time preferences and disagree about investors’ future time preferences and, thus, their future demands. There is speculative trade because investors perceive demand shocks differently and, thus, even in the absence of Merton’ type hedging demands or early resolution of uncertainty, these demand shocks, which are independent of output shocks, are priced in equilibrium. Our demand disagreement model can reconcile time-varying risk-free rates, excess stock market volatility, and the predictability of stock market returns by the price- dividend ratio, with a low correlation between macroeconomic fundamentals and both asset prices and trading volume. |
| Date: | 2018 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed018:607&r=upt |
| By: | Viero, Marie-Louise |
| Abstract: | This paper presents an intertemporal model of growing awareness. It provides a framework for analyzing problems with long time horizons in the presence of growing awareness and awareness of unawareness. The framework generalizes both the standard event-tree framework and the framework from Karni and Vier (2017) of awareness of unawareness. Axioms and a representation are provided along with a recursive formulation of intertemporal utility. This allows for tractable and consistent analysis of intertemporal problems with unawareness. |
| Keywords: | Financial Economics |
| Date: | 2017–09 |
| URL: | http://d.repec.org/n?u=RePEc:ags:quedwp:274714&r=upt |
| By: | Lockwood, Ben; Rockey, James |
| Abstract: | This paper studies how voter loss-aversion affects electoral competition in a Downsian setting. Assuming that the voters’ reference point is the status quo, we show that loss-aversion has a number of effects. First, for some values of the status quo, there is policy rigidity: both parties choose platforms equal to the status quo, regardless of other parameters. Second, there is a moderation effect when there is policy rigidity, the equilibrium policy outcome is closer to the moderate voters’ ideal point than in the absence of loss-aversion. In a dynamic extension of the model, we consider how parties strategically manipulate the status quo to their advantage, and we find that this decreases policy rigidity and increases moderation. Finally, we show that with loss-aversion, incumbents adjust less than challengers to changes in voter preferences, and as a result, favorable (unfavorable) preference shocks, from the point of view of the incumbent, intensify (reduce) electoral competition. These two predictions are new, and we test them using elections to US state legislatures, where we find empirical support for them. |
| Keywords: | Financial Economics |
| URL: | http://d.repec.org/n?u=RePEc:ags:uwarer:270220&r=upt |
| By: | Rodwell Kufakunesu; Calisto Guambe |
| Abstract: | In this paper, we study a stochastic optimal control problem with stochastic volatility. We prove the sufficient and necessary maximum principle for the proposed problem. Then we apply the results to solve an investment, consumption and life insurance problem with stochastic volatility, that is, we consider a wage earner investing in one risk-free asset and one risky asset described by a jump-diffusion process and has to decide concerning consumption and life insurance purchase. We assume that the life insurance for the wage earner is bought from a market composed of $M>1$ life insurance companies offering pairwise distinct life insurance contracts. The goal is to maximize the expected utilities derived from the consumption, the legacy in the case of a premature death and the investor's terminal wealth. |
| Date: | 2018–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1808.04608&r=upt |
| By: | Paulo Fagandini |
| Abstract: | I study the role the agent's wealth plays in the principal-agent matching with moral hazard and limited liability. I consider wealth and talent as the agent's type, and size as the firm's (principal's) type. Because utility is not perfectly transferable in this setup, I use generalized increasing differences and find that wealthier agents match with bigger firms, when talent is homogeneous among them, whereas for equally wealthy agents, more talented agents will match with bigger firms. I describe economic conditions over types such that pairs of higher types will write contracts in which the agent obtains more than the information rents, through a higher bonus, increasing the expected surplus. Finally, I provide an example in which wealth is distributed among agents in such a way that it reverses the standard result of positive assortative matching between talent and firm size. JEL codes: D86, D82, C78, J33, M12 |
| Keywords: | moral hazard, asymmetric information, matching, non transferable utility |
| Date: | 2017 |
| URL: | http://d.repec.org/n?u=RePEc:unl:unlfep:wp628&r=upt |
| By: | Dolatabadi, Sepideh; Kumar Narayan, Paresh; Orregaard Nielsen, Morten; Xu, Ke |
| Abstract: | Based on recent evidence of fractional cointegration in commodity spot and futures mar- kets, we investigate whether a fractionally cointegrated model can provide statistically and/or economically signicant forecasts of commodity returns. Specically, we propose to model and forecast commodity spot and futures prices using a fractionally cointegrated vector autoregres- sive (FCVAR) model that generalizes the more well-known (non-fractional) CVAR model to allow fractional integration. We derive the best linear predictor for the FCVAR model and perform an out-of-sample forecast comparison with the non-fractional model. In our empirical analysis to daily data on 17 commodity markets, the fractional model is found to be superior in terms of in-sample t and also out-of-sample forecasting based on statistical metrics of forecast comparison. We analyze the economic signicance of the forecasts through a dynamic trading strategy based on a portfolio with weights derived from a mean-variance utility function. Al- though there is much heterogeneity across commodity markets, this analysis leads to statistically signicant and economically meaningful prots in most markets, and shows that prots from both the fractional and non-fractional models are higher on average and statistically more signif- icant than prots derived from a simple moving-average strategy. The analysis also shows that, in spite of the statistical advantage of the fractional model, the fractional and non-fractional models generate very similar prots with only a slight advantage to the fractional model on average. |
| Keywords: | Financial Economics, Marketing |
| Date: | 2017–01 |
| URL: | http://d.repec.org/n?u=RePEc:ags:quedwp:274663&r=upt |
| By: | Pham, Thai Thuy Pham; Dao, The Anh; Theuvsen, Ludwig |
| Abstract: | This study addresses factors influencing the adoption of specialty rice variety among smallholder farmers in Vietnam. We used a sample of 336 farmers from the Red River Delta who were interviewed between October and December 2014. We follow the adoption behavior model based on the utility maximization criterion and adopt a two-step approach, starting with a Probit model for determinants of specialty rice adoption before analyzing the intensity of adoption using a Tobit model. Overall, 50% of the probability of specialty rice adoption is explained by the selected independent variables such as: cultivated land, experience in growing rice, and network size. Tobit model estimates show that group membership (such as in agricultural cooperatives, farmer’s union, etc.) and possession of a two-wheel-tractor increase the share of land allocation to specialty rice production by 3.4% and 7.8% respectively. Based on the findings manifold social and political implications will be derived. |
| Keywords: | Community/Rural/Urban Development, Production Economics |
| Date: | 2017–08–29 |
| URL: | http://d.repec.org/n?u=RePEc:ags:gagfdp:262581&r=upt |