nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2018‒09‒24
24 papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Cognitive Imprecision and Small-Stakes Risk Aversion By Mel Win Khaw; Ziang Li; Michael Woodford
  2. Adopting Bio-Energy Crops: Does Farmers Attitude toward Loss Matter? By Anand, Mohit; Miao, Ruiqing; Khanna, Madhu
  3. A Non-Bayesian Theory of State-Dependent Utility By Hill, Brian
  4. The Allais Paradox: What It Became, What It Really Was, What It Now Suggests to Us By Mongin, Philippe
  5. Portfolio diversification and model uncertainty: a robust dynamic mean-variance approach By Huyen Pham; Xiaoli Wei; Chao Zhou
  6. A New Keynesian Model with Wealth in the Utility Function By Pascal Michaillat; Emmanuel Saez
  7. Implementation without Expected Utility: Ex-Post Verifiability By Hitoshi Matsushima
  8. Should We Discount the Welfare of Future Generations? Ramsey and Suppes versus Koopmans and Arrow By Chichilnisky, Graciela; Hammond, Peter J.; Stern, Nicholas
  9. Risk Aversion And Pesticide Use: Further Insights From Prospect Theory By Carpentier, Alain
  10. Understanding how risk preferences and social capital affect farmers’ behavior to anticipatory and reactive adaptation options to climate change: the case of vineyard farmers in central Chile By Alvarado, E.; Ibanez, M.; Brummer, B.
  11. The Role of Trust in Explaining Food Choice: Combining Choice Experiments and Attribute Best Worst Scaling By Yeh, C.-H.; Hartmann, M.; Langen, N.
  12. Procedural and Optimization Implementation of the Weighted ENSC Value By Dongshuang Hou; Aymeric Lardon; Panfei Sun; Hao Sun
  13. Necessary and Sufficient Conditions for Existence and Uniqueness of Recursive Utilities By Jaroslav Borovicka; John Stachurski
  14. Combining Probability with Qualitative Degree-of-Certainty Metrics in Assessment By Helgeson, Casey; Bradley, Richard; Hill, Brian
  15. Neoclassical approach to traditional business insurance - introduction to the theory of agricultural insurance By Kulawik, Jacek
  16. Measurement Error in Prospect Theory Field Elicitations By Sproul, Thomas W.; Michaud, Clayton P.
  17. Simulating Crop Insurance Demand Under Prospect Theory By Sproul, Thomas W.; Michaud, Clayton P.
  18. The Implications of Financial Innovation for Capital Markets and Household Welfare By Buss, Adrian; Uppal, Raman; Vilkov, Grigory
  19. Spatial Discrete Choice Models: A Review Focused on Specification, Estimation and Health Economics applications By Giuseppe Arbia; Anna Gloria Billé
  20. Cognitive Ability and Bidding Behavior in Experimental Auction By Lee, Ji Yong; Nayga, Rodolfo M.; Deck, Cary; Drichoutis, Andreas
  21. Other-Regarding Preferences and Giving Decision in Risky Environments: Experimental Evidence. By MICKAEL BEAUD; MATHIEU LEFEBVRE; JULIE ROSAZ
  22. Fine-Tuning Willingness-To-Pay Estimates in Second Price Auctions By Kassas, Bachir; Palma, Marco A.; Anderson, David P.
  23. Household Portfolio Underdiversification and Probability Weighting: Evidence from the Field By Dimmock, Steve; Kouwenberg, Roy; Mitchell, Olivia S; Peijnenburg, Kim
  24. To Be or not to Be a Euro Country? The Behavioural Political Economics of Currency Unions By Donato Masciandaro; Davide Romelli

  1. By: Mel Win Khaw; Ziang Li; Michael Woodford
    Abstract: Observed choices between risky lotteries are difficult to reconcile with expected utility maximization, both because subjects appear to be too risk averse with regard to small gambles for this to be explained by diminishing marginal utility of wealth, as stressed by Rabin (2000), and because subjects' responses involve a random element. We propose a unified explanation for both anomalies, similar to the explanation given for related phenomena in the case of perceptual judgments: they result from judgments based on imprecise (and noisy) mental representations of the decision situation. In this model, risk aversion results from a sort of perceptual bias — but one that represents an optimal decision rule, given the imprecision of the mental representation of the situation. We propose a quantitative model of the noisy mental representation of simple lotteries, based on other evidence regarding numerical cognition, and test its ability to explain the choice frequencies that we observe in a laboratory experiment. Our model is more consistent with the laboratory data than random versions of expected utility theory or prospect theory, using both in-sample and out-of-sample tests of model fit.
    JEL: C91 D03 D81 D87
    Date: 2018–08
  2. By: Anand, Mohit; Miao, Ruiqing; Khanna, Madhu
    Abstract: This paper analyzes farmers’ willingness to grow a perennial energy crop (namely, miscanthus) while accounting for their attitude toward loss based on prospect theory. The analysis includes 1,877 U.S. counties east of the 100th Meridian that have data for corn yield and for miscanthus. We first estimate distributions of profits for miscanthus and conventional crops. The average probability of having a loss from growing miscanthus on high and low quality land for each county is calculated. We then study farmers’ optimal land allocation between miscanthus and conventional crops under prospect theory, and separately, under expected utility theory. Results show that all else equal, miscanthus production is lower when farmers’ loss aversion is considered than when loss aversion is ignored. Moreover, geographical configuration of miscanthus adoption predicted by prospect theory significantly differs from that predicted by expected utility theory.
    Keywords: Crop Production/Industries, Farm Management, Land Economics/Use
    Date: 2017–07–31
  3. By: Hill, Brian (HEC Paris - Economics & Decision Sciences; CNRS)
    Abstract: Many decision situations involve two or more of the following divergences from subjective expected utility: imprecision of beliefs (or ambiguity), imprecision of tastes (or multi-utility), and state dependence of utility. Examples include multi-attribute decisions under uncertainty, such as some climate decisions, where trade-offs across attributes may be state dependent. This paper proposes and characterises a model of uncertainty averse preferences that can simultaneously incorporate all three phenomena. The representation supports a principled separation of (imprecise) beliefs and (potentially state-dependent, imprecise) tastes, and we pinpoint the axiom that ensures such a separation. Moreover, the representation supports comparative statics of both beliefs and tastes, and is modular: it easily delivers special cases involving various combinations of the phenomena, as well as state-dependent multi-utility generalisations of popular ambiguity models.
    Keywords: state-dependent utility; uncertainty aversion; multiple priors; ambiguity; imprecise tastes; multi-utility
    JEL: D81
    Date: 2018–05–22
  4. By: Mongin, Philippe (GREGHEC; CNRS & HEC Paris - Economics & Decision Sciences)
    Abstract: Whereas many others have scrutinized the Allais paradox from a theoretical angle, we study the paradox from an historical perspective and link our findings to a suggestion as to how decision theory could make use of it today. We emphasize that Allais proposed the paradox as a normative argument, concerned with "the rational man" and not the "real man", to use his words. Moreover, and more subtly, we argue that Allais had an unusual sense of the normative, being concerned not so much with the rationality of choices as with the rationality of the agent as a person. These two claims are buttressed by a detailed investigation – the first of its kind – of the 1952 Paris conference on risk, which set the context for the invention of the paradox, and a detailed reconstruction – also the first of its kind – of Allais's specific normative argument from his numerous but allusive writings. The paper contrasts these interpretations of what the paradox historically represented, with how it generally came to function within decision theory from the late 1970s onwards: that is, as an empirical refutation of the expected utility hypothesis, and more specifically of the condition of von Neumann-Morgenstern independence that underlies that hypothesis. While not denying that this use of the paradox was fruitful in many ways, we propose another use that turns out also to be compatible with an experimental perspective. Following Allais's hints on "the experimental definition of rationality", this new use consists in letting the experiment itself speak of the rationality or otherwise of the subjects. In the 1970s, a short sequence of papers inspired by Allais implemented original ways of eliciting the reasons guiding the subjects' choices, and claimed to be able to draw relevant normative consequences from this information. We end by reviewing this forgotten experimental avenue not simply historically, but with a view to recommending it for possible use by decision theorists today.
    Keywords: Allais Paradox; Decision Theory; Expected Utility Theory; Experimental Economics; Positive vs Normative; Rationality; 1952 Paris Conference; Allais; Von Neumann and Morgenstern; Samuelson; Savage
    JEL: B21 B31 B41 C91 D80
    Date: 2018–06–01
  5. By: Huyen Pham (LPSM UMR 8001, ENSAE); Xiaoli Wei (LPSM UMR 8001); Chao Zhou (NUS)
    Abstract: This paper is concerned with a multi-asset mean-variance portfolio selection problem under model uncertainty. We develop a continuous time framework for taking into account ambiguity aversion about both expected return rates and correlation matrix of the assets, and for studying the effects on portfolio diversification. We prove a separation principle for the associated robust control problem, which allows to reduce the determination of the optimal dynamic strategy to the parametric computation of the minimal risk premium function. Our results provide a justification for under-diversification, as documented in empirical studies. We explicitly quantify the degree of under-diversification in terms of correlation and Sharpe ratio ambiguity. In particular, we show that an investor with a poor confidence in the expected return estimation does not hold any risky asset, and on the other hand, trades only one risky asset when the level of ambiguity on correlation matrix is large. This extends to the continuous-time setting the results obtained by Garlappi, Uppal and Wang [13], and Liu and Zeng [24] in a one-period model. JEL Classification: G11, C61 MSC Classification: 91G10, 91G80, 60H30
    Date: 2018–09
  6. By: Pascal Michaillat; Emmanuel Saez
    Abstract: This paper extends the New Keynesian model by introducing wealth, in the form of government bonds, into the utility function. The extension modifies the Euler equation: in steady state the real interest rate is negatively related to consumption instead of being constant, equal to the time discount rate. Thus, when the marginal utility of wealth is large enough, the dynamical system representing the equilibrium is a source not only in normal times but also at the zero lower bound. This property eliminates the zero-lower-bound anomalies of the New Keynesian model, such as explosive output and inflation, and forward-guidance puzzle.
    JEL: E31 E32 E43 E52
    Date: 2018–08
  7. By: Hitoshi Matsushima (University of Tokyo)
    Abstract: This study investigates implementation of a social choice function with complete information, where we impose various restrictions such as boundedness, permission of only small transfers, and uniqueness of iterative dominance in strict terms. We assume that the state is ex-post verifiable after the determination of allocation. We show that with three or more players, any social choice function is uniquely and exactly implementable in iterative dominance. Importantly, this study does not assume either expected utility or quasi-linearity, even if we utilize the stochastic method of mechanism design explored by Abreu and Matsushima (1992, 1994).
    Date: 2018–09
  8. By: Chichilnisky, Graciela (Columbia University); Hammond, Peter J. (Dept. of Economics and CAGE, University of Warwick); Stern, Nicholas (LSE)
    Abstract: Ramsey famously pronounced that discounting "future enjoyments" would be ethically indefensible. Suppes enunciated an equity criterion implying that all individuals' welfare should be treated equally. By contrast, Arrow (1999a, b) accepted, perhaps rather reluctantly, the logical force of Koopmans' argument that no satisfactory preference ordering on a sufficiently unrestricted domain of infinite utility streams satisfies equal treatment. In this paper, we first derive an equitable utilitarian objective based on a version of the Vickrey-Harsanyi original position, extended to allow a variable and uncertain population with no finite bound. Following the work of Chichilnisky and others on sustainability, slightly weakening the conditions of Koopmans and co-authors allows intergenerational equity to be satis ed. In fact, assuming that the expected total number of individuals who ever live is nite, and that each individual's utility is bounded both above and below, there is a coherent equitable objective based on expected total utility. Moreover, it implies the \extinction discounting rule" advocated by, inter alia, the Stern Review on climate change.
    Keywords: Discount rate ; utilitarianism ; consequentialization ; Vickrey-Harsanyi original position ; Suppes criterion ; optimal population ; average versus total utility ; intergenerational equity ; long-run discounting ; sustainable preferences ; extinction discounting rule JEL Classification: D63 ; D70 ; D90 ; Q54 ; Q56
    Date: 2018
  9. By: Carpentier, Alain
    Abstract: Prospect Theory suggests that farmers’ attitudes toward pest risks depend on the situation they refer to when facing crop protection decisions. Farmers referring to the ‘protected crop’ situation may implement self-insurance pesticide treatments while farmers referring to the ‘unprotected crop’ situation are risk neutral toward pest risks. Importantly, farmers are more likely to refer to the ‘protected crop’ situation when pesticides are relatively inexpensive. This in turn leads to original results related to the regulation of agricultural pesticide uses. For instance, pesticide taxes would not only impact pesticide expected profitability but also farmers’ attitude toward pest risks.
    Keywords: Environmental Economics and Policy
    Date: 2017–08–28
  10. By: Alvarado, E.; Ibanez, M.; Brummer, B.
    Abstract: The effects of climate change on agriculture have been widely studied. However, it is necessary to keep studying the responses that farmers could have to climate change. One of these responses is the adaptation. We have used anticipatory and reactive adaptation because we wanted to know if farmers prefer options to avoid or to face negative effects. The objective of this research was to understand how risk preferences along with social capital affect the decision to implement anticipatory or reactive adaptation options to climate change. This study took place in central Chile, data were collected through a field experiment from September to December 2016 with 163 vineyard farmers; we used the structural and midpoint methods to estimate the Cumulative Prospect Theory (CPT) parameters. Finally, we identify 5 anticipatory and 4 reactive adaptation options. The parameters indicate vineyard farmers are strongly risk averse and sensitive to losses, and their determinants are grape area, membership and subjective norms for risk aversion, and age, household size, and education for loss aversion. The main drivers for anticipatory adaptation are network, trust, time to market and area, and the main drivers for reactive adaptation are risk aversion, institutional trust, age and time to market.
    Keywords: Agricultural and Food Policy, Farm Management, International Development
    Date: 2018–07
  11. By: Yeh, C.-H.; Hartmann, M.; Langen, N.
    Abstract: This paper presents empirical findings from a combination of two elicitation techniques: discrete choice experiment (DCE) and best-worst scaling (BWS) to provide information about the role of consumers’ trust in food choice decisions in the case of credence attributes. The analysis is carried out at the example of Taiwan and focuses on sweet red peppers. DCE data is examined using latent class analysis to investigate the importance and the utility different consumer segments attach to process attributes and their respective levels: production method, country of origin and chemical residual testing. The relevance of attitudinal and trust based items is analyzed by BWS using hierarchical Bayesian mixed logit model. Applying multinomial logit model participant’s latent class membership (obtained from DCE data) is regressed on the identified attitudinal and trust components considering, in addition, demographic information. The analysis is based on a sample of 459 Taiwanese consumers. Results of the DCE latent class analysis for the product attributes show that four distinct segments can be distinguished. Linking the DCE with the attitudinal dimensions reveals that consumers’ attitude and trust significantly explains class membership. Hence, consumers’ food purchase behavior is determined by consumers’ trust in products from respective counties products, labels, and institutions.
    Keywords: Agricultural and Food Policy, Food Consumption/Nutrition/Food Safety
    Date: 2018–07
  12. By: Dongshuang Hou (Department of Applied Mathematics, Northwestern Polytechnical University); Aymeric Lardon (Université Côte d'Azur, France; GREDEG CNRS); Panfei Sun (Department of Applied Mathematics, Northwestern Polytechnical University); Hao Sun (Department of Applied Mathematics, Northwestern Polytechnical University)
    Abstract: The main purpose of this article is to introduce the weighted ENSC value for cooperative transferable utility games which takes into account players' selfishness about the payoff allocations. Similarly to Shapley's idea of a one-by-one formation of the grand coalition (Shapley, 1953), we first provide a procedural implementation of the weighted ENSC value depending on players' selfishness as well as their marginal contributions to the grand coalition. Second, in the spirit of the nucleolus (Schmeidler, 1969), we prove that the weighted ENSC value is obtained by lexicographically minimizing a complaint vector associated with a new complaint criterion relying on players' selfishness.
    Keywords: TU-game, weighted ENSC value, allocation scenario, selissh complaint
    JEL: C71
    Date: 2018–09
  13. By: Jaroslav Borovicka (New York University); John Stachurski (Research School of Economics)
    Abstract: We study existence, uniqueness and stability of solutions for a class of discrete time recursive utilities models. By combining two streams of the recent literature on recursive preferences—one that analyzes principal eigenvalues of valuation operators and another that exploits the theory of monotone concave operators—we obtain conditions that are both necessary and sufficient for existence and uniqueness. We also show that the natural iterative algorithm is convergent if and only if a solution exists. Consumption processes are allowed to be nonstationary.
    Date: 2018
  14. By: Helgeson, Casey (London School of Economics & Political Science (LSE)); Bradley, Richard (London School of Economics & Political Science (LSE) - Department of Philosophy); Hill, Brian (HEC Paris - Economics & Decision Sciences; CNRS)
    Abstract: Reports of the Intergovernmental Panel on Climate Change (IPCC) employ an evolving framework of calibrated language for assessing and communicating degrees of certainty in findings. A persistent challenge for this framework has been ambiguity in the relationship between multiple degree-of-certainty metrics. We aim to clarify the relationship between the likelihood and confidence metrics used in the Fifth Assessment Report (2013), with benefits for mathematical consistency among multiple findings and for usability in downstream modeling and decision analysis. We discuss how our proposal meshes with current and proposed practice in IPCC uncertainty assessment.
    Keywords: confidence; uncertainty reporting; climate change
    JEL: D81
    Date: 2018–01–17
  15. By: Kulawik, Jacek
    Abstract: The contemporary agriculture is among the most risky economic activities. In addition to the previously known production, price and market risk, and later also the financial risk, today agricultural producers are increasingly more often confronted with institutional risk and personnel management risk and risk related to climate change. On the other hand, farmers have at their disposal numerous tools and strategies to counteract threats and mitigate their negative effects. Among these risk management instruments and strategies, traditional/ conventional insurance of crops, livestock and tangible assets is still important. In this context, the basic goal of the article is to generalise the theoretical foundations of the above-mentioned insurance, but limited to their historically oldest approach; hence on the basis of neoclassical microeconomics and classical decision theory. According to the convention existing, the essence of the theory/hypothesis of the expected utility of von Neumann–Morgenstern is first analysed. In the last part of the article, the assumptions of the expected utility theory are concretised on the example of agricultural insurance.
    Keywords: Agricultural and Food Policy, Agricultural Finance, Financial Economics
    Date: 2018
  16. By: Sproul, Thomas W.; Michaud, Clayton P.
    Keywords: Risk and Uncertainty
    Date: 2018–04–06
  17. By: Sproul, Thomas W.; Michaud, Clayton P.
    Keywords: Risk and Uncertainty
    Date: 2018–04–07
  18. By: Buss, Adrian; Uppal, Raman; Vilkov, Grigory
    Abstract: Our objective is to understand how financial innovation affects investors' optimal asset-allocation decisions and the economic mechanisms through which these decisions influence financial markets, welfare, and wealth inequality. We show that when some investors, such as households, are less confident than other investors about the dynamics of the new asset made available by financial innovation, but learn over time, many ''intuitive'' results are reversed: financial innovation increases the return volatility and risk premium of the new asset along with volatilities of investors' portfolios. Despite the increase in volatilities, financial innovation improves the welfare of all investors but worsens wealth inequality because experienced investors benefit more from it.
    Keywords: Bayesian Learning; differences in beliefs; household finance; household portfolio choice; parameter uncertainty; recursive utility; Wealth Inequality
    JEL: D53 G11 G12
    Date: 2018–08
  19. By: Giuseppe Arbia (Catholic University of the Sacred Heart, Rome, Department of Statistical Science); Anna Gloria Billé (Free University of Bozen-Bolzano, Faculty of Economics and Management)
    Abstract: Modeling individual choices is one of the main aim in microeconometrics. Discrete choice models have been widely used to describe economic agents' utility functions, and most of them play a paramount role in applied health economics. On the other hand, spatial econometrics collects a series of econometric tools which are particularly useful when we deal with spatially-distributed data sets. It has been demonstrated that accounting for spatial dependence can avoid inconsistency problems of the commonly used estimators. However, the complex structure of spatial dependence in most of the nonlinear models still precludes a large diffusion of these spatial techniques. The purpose of this paper is then twofold. The former is to review the main methodological problems and their different solutions in spatial discrete choice modeling as they have appeared in the econometric literature. The latter is to review their applications to health issues, especially in the last few years, by highlighting at least two main reasons why spatial discrete neighboring effects should be considered and then suggesting possible future lines of the development of this emerging field.
    Keywords: Discrete Choice Modeling, Health Economics, Spatial Econometrics
    JEL: C31 C35 C51 I10
    Date: 2018–09
  20. By: Lee, Ji Yong; Nayga, Rodolfo M.; Deck, Cary; Drichoutis, Andreas
    Keywords: Institutional and Behavioral Economics, Research Methods/Statistical Methods
    Date: 2017–07–03
    Abstract: This paper investigates if and how other-regarding preferences governing giving decisions in dictator games are affected in risky environments in which the payoff of the recipient is random. We demonstrate that, whenever the risk is actuarially neutral, the donation of dictators with a purely ex post view of fairness should, in general, be affected by the riskyness of the recipient’s payoff, while dictators with a purely ex ante view should not be. Our experimental data give weak empirical support to the purely ex post view of fairness.
    Keywords: Laboratory experiments dictator games, background risk, otherregarding preferences, inequality aversion, impure altruism, ex ante and ex post views of fairness.
    JEL: C91 D64 D81
    Date: 2018
  22. By: Kassas, Bachir; Palma, Marco A.; Anderson, David P.
    Keywords: Institutional and Behavioral Economics, Research Methods/Statistical Methods, Risk and Uncertainty
    Date: 2017–07–03
  23. By: Dimmock, Steve; Kouwenberg, Roy; Mitchell, Olivia S; Peijnenburg, Kim
    Abstract: We explore the relation between probability weighting and household portfolio underdiversification in a representative household survey, using custom-designed incentivized lotteries. On average, people display Inverse-S shaped probability weighting, overweighting the small probabilities of tail events. As theory predicts, our Inverse-S measure is positively associated with portfolio underdiversification, which results in significant Sharpe ratio losses. We match respondents' individual stock holdings to CRSP data and find that people with higher Inverse-S tend to pick stocks with positive skewness and hold positively-skewed equity portfolios. We show that these choices reflect preferences rather than probability unsophistication or limited financial knowledge.
    Keywords: cumulative prospect theory; household finance; household portfolio puzzles; portfolio underdiversification; probability weighting; rank dependent utility; Stock Market Participation
    JEL: C83 D14 D81 G11
    Date: 2018–08
  24. By: Donato Masciandaro; Davide Romelli
    Abstract: The aim of this paper is to use a behavioural political economy approach to revise the standard approach of optimal currency areas, and applying it to the Eurozone case. We discuss the pros and cons of the Euro membership if behavioural biases - prospect theory - influence the citizens and consequently the political actors. The theoretical framework is used to analyse in general under which conditions the Euro irreversibility assumption is likely to hold and specifically the support in favour of the Euro membership in a country case.
    Date: 2018

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