nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2018‒11‒05
twenty-two papers chosen by

  1. Expected Utility Preferences versus Prospect Theory Preferences in Bargaining By Khan, Abhimanyu
  2. A Path Integral Approach to Business Cycle Models with Large Number of Agents By Gosselin, Pierre; Lotz, Aïleen; Wambst, Marc
  3. Time will tell: recovering preferences when choices are noisy By Carlos Alós-Ferrer; Ernst Fehr; Nick Netzer
  4. A Test of Dynamic Consistency and Consequentialism in the Presence of Ambiguity By Han Bleichrodt; Jurgen Eichberger; Simon Grant; David Kelsey; Chen Li
  5. Loss Attitudes in the U.S. Population: Evidence from Dynamically Optimized Sequential Experimentation (DOSE) By Jonathan Chapman; Erik Snowberg; Stephanie Wang; Colin Camerer
  6. Corruption vs reforms: Why do voters prefer the former? By Fedotenkov, Igor
  7. Framing Discrete Choice Model as Deep Neural Network with Utility Interpretation By Shenhao Wang; Jinhua Zhao
  8. On the role of probability weighting on WTP for crop insurance with and without yield skewness By Bougherara, Douadia; Piet, Laurent
  9. Global Closed-form Approximation of Free Boundary for Optimal Investment Stopping Problems By Jingtang Ma; Jie Xing; Harry Zheng
  10. Dividend Policy and Capital Structure of a Defaultable Firm By Alex S. L. Tse
  11. Bankruptcy Problems with Reference-Dependent Preferences By Andrea Gallice
  12. Inequality Measurement with an Ordinal and Continuous Variable By Nicolas Gravel; Brice Magdalou; Patrick Moyes
  13. Betrayal Aversion and the Effectiveness of Incentive Contracts By Rau, Holger; Müller, Stephan
  14. Climatic Roots of Loss Aversion By Galor, Oded; Savitskiy, Viacheslav
  15. The Empirical Content of Marital Surplus in Matching Models By Doorley, Karina; Dupuy, Arnaud; Weber, Simon
  16. Redistribution and Fiscal Uncertainty Shocks By Hikaru Saijo
  17. Growth, Mobility and Social Welfare By Dirk Van de gaer; Flaviana Palmisano
  18. Revealed Preference Analysis with Framing Effects By Jacob Goldin; Daniel Reck
  19. Completeness and Transitivity of Preferences on Mixture Sets By Tsogbadral Galaabaatar; M. Ali Khan; Metin Uyan{\i}k
  20. Better understanding of Demand for Weather Index Insurance among Smallholder Farmers under Prospect Theory By Shin, Soye
  21. The Banks' Swansong: Banking and the Financial Markets under Asymmetric Information By Jungu Yang
  22. A General Sensitivity Analysis Approach for Demand Response Optimizations By Ding Xiang; Ermin Wei

  1. By: Khan, Abhimanyu
    Abstract: Are individuals always better off when their preferences can be represented by expected utility? I study this question in a bargaining game where individuals bargain over a pie of fixed size, and I contrast the share received in the long-run by expected utility maximisers with the share they would receive if their preferences were described by prospect theory preferences instead when, in either case, they bargain with expected utility maximisers. I present a necessary and sufficient condition for individuals to obtain a higher share of the pie if their preferences obey prospect theory rather than expected utility. I decompose the effect that the three features that characterise prospect theory preferences -- reference point dependence, loss-aversion and probability weighting -- have on the bargaining outcome, and show that loss-aversion does not have any effect on the outcome of the bargaining process, reference-point dependent preference confers an unambiguous advantage and probability weighting is unambiguously disadvantageous. This ties in with the main result outlined earlier: if the upward pull of reference point dependence is relatively stronger than the downward push of probability weighting, then individuals are better off with prospect theory preferences than with expected utility preferences, and vice-versa.
    Keywords: bargaining, expected utility prospect theory, reference point dependence, loss aversion, probability weighting
    JEL: C73 C78 D01 D81 D83
    Date: 2018–10–06
  2. By: Gosselin, Pierre; Lotz, Aïleen; Wambst, Marc
    Abstract: This paper presents an analytical treatment of economic systems with an arbitrary number of agents that keeps track of the systems' interactions and agents' complexity. This formalism does not seek to aggregate agents. It rather replaces the standard optimization approach by a probabilistic description of both the entire system and agents' behaviors. This is done in two distinct steps. A first step considers an interacting system involving an arbitrary number of agents, where each agent's utility function is subject to unpredictable shocks. In such a setting, individual optimization problems need not be resolved. Each agent is described by a time-dependent probability distribution centered around his utility optimum. The entire system of agents is thus defined by a composite probability depending on time, agents' interactions and forward-looking behaviors. This dynamic system is described by a path integral formalism in an abstract space - the space of the agents' actions - and is very similar to a statistical physics or quantum mechanics system. We show that this description, applied to the space of agents' actions, reduces to the usual optimization results in simple cases. Compared to a standard optimization, such a description markedly eases the treatment of systems with small number of agents. It becomes however useless for a large number of agents. In a second step therefore, we show that for a large number of agents, the previous description is equivalent to a more compact description in terms of field theory. This yields an analytical though approximate treatment of the system. This field theory does not model the aggregation of a microeconomic system in the usual sense. It rather describes an environment of a large number of interacting agents. From this description, various phases or equilibria may be retrieved, along with individual agents' behaviors and their interactions with the environment. For illustrative purposes, this paper studies a Business Cycle model with a large number of agents.
    Keywords: path integrals, statistical field theory, business cycle, budget constraint, multi-agent model, interacting agents.
    JEL: C02 C60 E00 E1
    Date: 2018–10
  3. By: Carlos Alós-Ferrer; Ernst Fehr; Nick Netzer
    Abstract: The ability to uncover preferences from choices is fundamental for both positive economics and welfare analysis. Overwhelming evidence shows that choice is stochastic, which has given rise to random utility models as the dominant paradigm in applied microeconomics. However, as is well known, it is not possible to infer the structure of preferences in the absence of assumptions on the structure of noise. This makes it impossible to empirically test the structure of noise independently from the structure of preferences. Here, we show that the difficulty can be bypassed if data sets are enlarged to include response times. A simple condition on response time distributions (a weaker version of first-order stochastic dominance) ensures that choices reveal preferences without assumptions on the structure of utility noise. Sharper results are obtained if the analysis is restricted to specific classes of models. Under symmetric noise, response times allow to uncover preferences for choice pairs outside the data set, and if noise is Fechnerian, even choice probabilities can be forecast out of sample. We conclude by showing that standard random utility models from economics and standard drift-diffusion models from psychology necessarily generate data sets fulfilling our sufficient condition on response time distributions.
    Keywords: Revealed preference, random utility models, response times
    JEL: D11 D81 D83 D87
    Date: 2018–10
  4. By: Han Bleichrodt; Jurgen Eichberger; Simon Grant; David Kelsey (Department of Economics, University of Exeter); Chen Li
    Abstract: We test dynamic consistency and consequentialism, two key principles of dynamic decision making under ambiguity and relate violations of these principles to subjectsÕ ambiguity at- titudes. In our experiment, subjects received a signal which made it attractive for ambiguity averse subjects to deviate from their ex- ante contingent plan and violate dynamic consistency. We found that ambiguity averse subjects were indeed more likely to violate dynamic consistency than ambiguity neutral subjects, but not consequentialism.
    Keywords: ambiguity, three-color Ellsberg paradox, consequentialism, dynamic consistency.
    JEL: D72 D81
    Date: 2018
  5. By: Jonathan Chapman; Erik Snowberg; Stephanie Wang; Colin Camerer
    Abstract: We introduce DOSE - Dynamically Optimized Sequential Experimentation - and use it to estimate individual-level loss aversion in a representative sample of the U.S. population (N = 2;000). DOSE elicitations are more accurate, more stable across time, and faster to administer than standard methods. We find that around 50% of the U.S. population is loss tolerant. This is counter to earlier findings, which mostly come from lab/student samples, that a strong majority of participants are loss averse. Loss attitudes are correlated with cognitive ability: loss aversion is more prevalent in people with high cognitive ability, and loss tolerance is more common in those with low cognitive ability. We also use DOSE to document facts about risk and time preferences, indicating a high potential for DOSE in future research.
    Keywords: dynamic experiments, DOSE, loss aversion, risk preferences, time preferences
    JEL: C81 C90 D81 D90
    Date: 2018
  6. By: Fedotenkov, Igor
    Abstract: In this paper, we address the question of why voters tolerate corrupt politicians. Standard economic techniques such as expected utility maximization under uncertainty are employed. We show that a corrupt politician is less likely to institute reforms which can cause short-term losses for voters during a transitional period or lead with some probability to non-success. Voters' higher risk aversion causes an increased fear of reforms and higher tolerance for corruption. We also show that during an economic crisis the corruptionists' optimal strategy is not to institute reforms, as models with honest politicians predict, but to reduce the level of corruption. Using panel data techniques, we show that such a strategy is in line with the empirical CIS data; however, it follows with a short delay.
    Keywords: Corruption; politician; median voter; reforms; risk aversion
    JEL: D72 D73 D79 E60 I38 O43
    Date: 2018–10–18
  7. By: Shenhao Wang; Jinhua Zhao
    Abstract: Deep neural network (DNN) has been increasingly applied to travel demand prediction. However, no study has examined how DNN relates to utility-based discrete choice models (DCM) beyond simple comparison of prediction accuracy. To fill this gap, this paper investigates the relationship between DNN and DCM from a theoretical perspective with three major findings. First, we introduce the utility interpretation to the DNN models and demonstrate that DCM is one special case of DNN with shallow and sparse architecture, identifiable parameters, logistic loss, zero regularization, and domain-knowledge based feature transformation. Second, a sequence of four neural network models illustrate how DNN gradually trade away interpretability for predictability in the context of travel mode choice. High predictability is achieved by DNN's powerful representation learning and high model capacity; but interpretability is sacrificed through the loss of convex optimization and statistical properties, and non-identification of parameters. Third, the utility interpretation allows us to develop a numerical method of extracting important economic information from DNN including choice probability, elasticity, marginal rate of substitution, and consumer surplus. Overall, this study makes three contributions: theoretically it frames DCM as a special case of DNN and introduces the utility interpretation to DNN; methodologically it demonstrates the interpretability-predictability tradeoff between DCM and DNN and suggests the potential of their joint improvement, and practically it introduces a post-hoc numerical method to extract economic information from DNN and make it interpretable through the utility concept.
    Date: 2018–10
  8. By: Bougherara, Douadia; Piet, Laurent
    Abstract: A growing number of studies in finance and economics seek to explain insurance choices us- ing the assumptions advanced by behavioral economics. One recent example in agricultural economics is the use of cumulative prospect theory (CPT) to explain farmer choices regarding crop insurance coverage levels (Babcock, 2015). We build upon this framework by deriving willingness to pay (WTP) for insurance programs under alternative assumptions, thus extend- ing the model to incorporate farmer decisions regarding whether or not to purchase insurance. Our contribution is twofold. First, we study the sensitivity of farmer WTP for crop insurance to the inclusion of CPT parameters. We find that loss aversion and probability distortion in- crease WTP for insurance while risk aversion decreases it. Probability distortion in losses plays a particularly important role. Second, we study the impact of yield distribution skewness on farmer WTP assuming CPT preferences. We find that WTP decreases when the distribution of yields moves from negatively- to positively-skewed and that the combined effect of proba- bility weighting in losses and skewness has a large negative impact on farmer WTP for crop insurance.
    Keywords: Risk and Uncertainty
    Date: 2018
  9. By: Jingtang Ma; Jie Xing; Harry Zheng
    Abstract: In this paper we study a utility maximization problem with both optimal control and optimal stopping in a finite time horizon. The value function can be characterized by a variational equation that involves a free boundary problem of a fully nonlinear partial differential equation. Using the dual control method, we derive the asymptotic properties of the dual value function and the associated dual free boundary for a class of utility functions, including power and non-HARA utilities. We construct a global closed-form approximation to the dual free boundary, which greatly reduces the computational cost. Using the duality relation, we find the approximate formulas for the optimal value function, trading strategy, and exercise boundary for the optimal investment stopping problem. Numerical examples show the approximation is robust, accurate and fast.
    Date: 2018–10
  10. By: Alex S. L. Tse
    Abstract: Default risk significantly affects the corporate policies of a firm. We develop a model in which a limited liability entity subject to Poisson default shock jointly sets its dividend policy and capital structure to maximize the expected lifetime utility from consumption of risk averse equity investors. We give a complete characterization of the solution to the singular stochastic control problem. The optimal policy involves paying dividends to keep the ratio of firm's equity value to investors' wealth below a critical threshold. Dividend payout acts as a precautionary channel to transfer wealth from the firm to investors for mitigation of losses in the event of default. Higher the default risk, more aggressively the firm leverages and pays dividends.
    Date: 2018–10
  11. By: Andrea Gallice
    Abstract: I study bankruptcy problems under the assumption that claimants have referencedependent preferences. I consider different specifications for claimants’ reference points and show how perceived gains and losses impact on aggregate welfare. I can thus rank the four most prominent rules (Proportional, Constrained Equal Awards, Constrained Equal Losses, and Talmud) on the basis of the level of utilitarian and maxmin welfare that they generate. When none of these rules maximizes welfare, I identify the rule that does it and discuss its properties.
    Keywords: bankruptcy problems, reference-dependent preferences, reference points, utilitarian welfare, maxmin welfare.
    JEL: D63 D03
    Date: 2018
  12. By: Nicolas Gravel; Brice Magdalou; Patrick Moyes
    Abstract: What would be the analogue of the Lorenz quasi-ordering when the variable of interest is continuous and of a purely ordinal nature? We argue that it is possible to derive such a criterion by substituting for the Pigou-Dalton transfer used in the standard inequality literature what we refer to as a Hammond progressive transfer. According to this criterion, one distribution of utilities is considered to be less unequal than another if it is judged better by both the lexicographic extensions of the maximin and the minimax, henceforth referred to as the leximin and the antileximax, respectively. If one imposes in addition that an increase in someone\'s utility makes the society better off, then one is left with the leximin, while the requirement that society welfare increases as the result of a decrease of one person\'s utility results in the antileximax criterion. Incidentally, the paper provides an alternative and simple characterisation of the leximin principle widely used in the social choice and welfare literature.
    Keywords: Ordinal inequality, Hammond equity principle, Leximin, Antileximax
    JEL: D30 D63
    Date: 2018
  13. By: Rau, Holger; Müller, Stephan
    Abstract: In this paper we study the impact of betrayal aversion on agents' effort provision, when principals have discretion regarding agents' remuneration. We show theoretically that agents who work under a nonbinding bonus contract face a trade off in their effort choice between the likelihood and the level of betrayal. Thus, depending on which effect predominates, betrayal aversion may either undermine or underpin the effectiveness of bonus contracts to induce effort. The data of our experiment reveal a strong detrimental effect of betrayal aversion. If the principal promises to pay a bonus for sufficiently high effort, the message is ineffective when agents are characterized by a high degree of betrayal aversion. In strong contrast, employees with a low degree of betrayal aversion increase their performance by more than 50%, if they received this message. The findings in this article identify an additional hidden cost of economic incentives.
    Keywords: Betrayal Aversion,Principal Agent Problem,Experiment
    JEL: C91 D03 D81
    Date: 2018
  14. By: Galor, Oded (Brown University); Savitskiy, Viacheslav (Brown University)
    Abstract: This research explores the origins of loss aversion and the variation in its prevalence across regions, nations and ethnic group. It advances the hypothesis and establishes empirically that the evolution of loss aversion in the course of human history can be traced to the adaptation of individuals to the asymmetric effects of climatic shocks on reproductive success during the Malthusian epoch in which subsistence consumption was a binding constraint. Exploiting regional variations in the vulnerability to climatic shocks and their exogenous changes in the course of the Columbian Exchange, the research establishes that consistent with the predictions of the theory, individuals and ethnic groups that are originated in regions marked by greater climatic volatility have higher predisposition towards loss-neutrality, while descendants of regions in which climatic conditions tended to be spatially correlated, and thus shocks were aggregate in nature, are characterized by greater intensity of loss aversion.
    Keywords: loss aversion, cultural evolution, evolution of preferences, natural selection, Malthusian epoch, growth, development
    JEL: D81 D91 Z10 O10 O40
    Date: 2018–09
  15. By: Doorley, Karina (Economic and Social Research Institute, Dublin); Dupuy, Arnaud (University of Luxembourg); Weber, Simon (KU Leuven)
    Abstract: This note investigates the extent to which structural estimates of marital surplus are informative about subjective well-being and separation. We first estimate the marital surplus using a simple matching model of the marriage market with perfectly transferable utility and heterogeneity in tastes applied to a rich German panel dataset. We then show that these estimates of the marital surplus are negatively correlated with separation and the difference in spouses' subjective satisfaction.
    Keywords: matching market, marital surplus, subjective well-being, separation
    JEL: C78 D1
    Date: 2018–09
  16. By: Hikaru Saijo (University of California, Santa Cruz (E-mail:
    Abstract: This paper studies the macroeconomic impact of an uncertainty shock about fiscal policy in a dynamic general equilibrium framework. Motivated by the observation that many fiscal policies are redistributive and that a sizable fraction of U.S. households do not own capital, I introduce household heterogeneity in the form of limited capital market participation. I show that household heterogeneity significantly magnifies the aggregate effect and induces co-movement of macroeconomic variables in a contraction that is generated by a fiscal uncertainty shock. This is because the limited capital market participation model captures individual uncertainty about redistribution that is absent in representative agent models. When agents are ambiguity averse, this uncertainty about redistribution has first-order effects because it shows up as heterogeneous worst-case scenarios. As a result, the model matches the empirical responses of macro variables to fiscal uncertainty shocks better than the representative agent counterpart.
    Keywords: fiscal policy uncertainty, ambiguity, limited stock market participation, redistribution
    JEL: E32 E62
    Date: 2018–10
  17. By: Dirk Van de gaer; Flaviana Palmisano
    Abstract: We propose a social welfare function to evaluate a profile of income streams and compare the welfare gain of the actual profile relative to the income profile where the individual receives his first period income in each period. We derive necessary and sufficient conditions for the welfare gain to be positive, and show how this welfare gain can be decomposed in a pure effect of economic growth, a mobility effect and a cost due to aversion to time fluctuations given individuals’ ranks in the income distribution. The mobility effect, generated by reranking in the income distribution has two components: a cost due to the time fluctuations in incomes and a benefit, due to the equalization in time averaged incomes. We illustrate the analysis using CNEF data for Australia, Korea, Germany and Switzerland. Our results indicate that the largest component of the welfare gain is the equalization of time averaged income, induced by reranking. After subtracting the cost of mobility due to the increase in time fluctuations of individual income streams, the net effect of mobility remains positive. In countries with high growth (Australia and Korea), the growth effect is larger than the mobility effect, but in countries with low growth (Germany and Switzerland), the opposite holds true.
    Keywords: intertemporal growth; mobility; income streams; time horizon
    JEL: D31 D63 I32
    Date: 2018
  18. By: Jacob Goldin; Daniel Reck
    Abstract: In many settings, decision-makers' behavior is observed to vary based on seemingly arbitrary factors. Such framing effects cast doubt on the welfare conclusions drawn from revealed preference analysis. We relax the assumptions underlying that approach to accommodate settings in which framing effects are present. Plausible restrictions of varying strength permit either partial- or point-identification of preferences for the decision-makers who choose consistently across frames. Recovering population preferences requires understanding the empirical relationship between decision-makers’ preferences and their sensitivity to the frame. We develop tools for studying this relationship and illustrate them with data on automatic enrollment into pension plans.
    JEL: C1 D03 D60
    Date: 2018–10
  19. By: Tsogbadral Galaabaatar; M. Ali Khan; Metin Uyan{\i}k
    Abstract: In this paper, we show that the presence of the Archimedean and the mixture-continuity properties of a binary relation, both empirically non-falsifiable in principle, foreclose the possibility of consistency (transitivity) without decisiveness (completeness), or decisiveness without consistency, or in the presence of a weak consistency condition, neither. The basic result can be sharpened when specialized from the context of a generalized mixture set to that of a mixture set in the sense of Herstein-Milnor (1953). We relate the results to the antecedent literature, and view them as part of an investigation into the interplay of the structure of the choice space and the behavioral assumptions on the binary relation defined on it; the ES research program due to Eilenberg (1941) and Sonnenschein (1965), and one to which Schmeidler (1971) is an especially influential contribution.
    Date: 2018–10
  20. By: Shin, Soye
    Keywords: Risk and Uncertainty, Experimental Economics, International Development
    Date: 2018–06–20
  21. By: Jungu Yang (Economic Research Institute, The Bank of Korea)
    Abstract: Bank runs may serve to communicate information across agents, and thus enhance rather than thwart allocation efficiency by making the fundamentals determine the asset prices. Figuratively speaking, banks die (go bankrupt) singing a swan song (revealing hidden information). In this way bank runs help uninformed agents to achieve efficient allocation under the condition of asymmetric information in the financial markets. The production of information is done efficiently without cost a point which distinguishes between this paper from most other related studies. The efficiently bank runs provide new ground for the coexistence of banks and financial markets. Even when all agents deposit their whole endowment of goods with the bank, the markets play their role in allocating resources once efficient bank runs happen. Allowing a run implies that investment in liquidity can be minimized, and the expected utility of uninformed agents thus increased. The role of banks is strengthened when agents have limited access to the markets.
    Keywords: Financial intermediation, Financial markets, Bank runs, Asset price, Asymmetric information, Information acquisition, Limited participation, Liquidity
    JEL: D4 D5 D8 G1 G2
    Date: 2018–06–15
  22. By: Ding Xiang; Ermin Wei
    Abstract: It is well-known that demand response can improve the system efficiency as well as lower consumers' (prosumers') electricity bills. However, it is not clear how we can either qualitatively identify the prosumer with the most impact potential or quantitatively estimate each prosumer's contribution to the total social welfare improvement when additional resource capacity/flexibility is introduced to the system with demand response, such as allowing net-selling behavior. In this work, we build upon existing literature on the electricity market, which consists of price-taking prosumers each with various appliances, an electric utility company and a social welfare optimizing distribution system operator, to design a general sensitivity analysis approach (GSAA) that can estimate the potential of each consumer's contribution to the social welfare when given more resource capacity. GSAA is based on existence of an efficient competitive equilibrium, which we establish in the paper. When prosumers' utility functions are quadratic, GSAA can give closed forms characterization on social welfare improvement based on duality analysis. Furthermore, we extend GSAA to a general convex settings, i.e., utility functions with strong convexity and Lipschitz continuous gradient. Even without knowing the specific forms the utility functions, we can derive upper and lower bounds of the social welfare improvement potential of each prosumer, when extra resource is introduced. For both settings, several applications and numerical examples are provided: including extending AC comfort zone, ability of EV to discharge and net selling. The estimation results show that GSAA can be used to decide how to allocate potentially limited market resources in the most impactful way.
    Date: 2018–10

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