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on Utility Models and Prospect Theory |
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Issue of 2019‒01‒21
twelve papers chosen by |
| By: | Mark Schneider (University of Alabama) |
| Abstract: | In a market where some traders are rational (maximize expected utility) and others are systematically biased (deviate from expected utility due to some bias parameter, ?), do equilibrium prices necessarily depend on ?? In this note, focusing on the case where there is an aggregate and systematic bias inthe population, we show that market prices can still be unbiased. Hence, we establish that systematically biased agents do not necessarily imply biased market prices. We show that the parametric model we use also predicts observed deviations from expected utility in laboratory and market environments. |
| Keywords: | Risk aversion; Expected utility; Bias Aggregation |
| JEL: | D81 D90 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:chu:wpaper:19-03&r=all |
| By: | Mass, Helene |
| Abstract: | I investigate the decision problem of a player in a game of incomplete information who faces uncertainty about the other players' strategies. I propose a new decision criterion which works in two steps. First, I assume common knowledge of rationality and eliminate all strategies which are not rationalizable. Second, I apply the maximin expected utility criterion. Using this decision criterion, one can derive predictions about outcomes and recommendations for players facing strategic uncertainty. A bidder following this decision criterion in a first-price auction expects all other bidders to bid their highest rationalizable bid given their valuation. As a consequence, the bidder never expects to win against an equal or higher type and resorts to win against lower types with certainty. |
| Keywords: | Auctions,Incomplete Information,Informational Robustness,Rationalizability |
| JEL: | C72 D81 D82 D83 |
| Date: | 2018 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:zewdip:18055&r=all |
| By: | Joaquín Gómez Miñambres (Lafayette College); Mark Schneider (University of Alabama) |
| Abstract: | Employment contracts often have a three-tiered structure, offering a base salary, a bonus for high performance and a penalty for poor performance. None of the standard models in contract theory generate such a contract. We show that such coarse contracts are optimal in a model where the agent exhibits two of the most robust deviations from expected utility theory: skewness preference and ambiguity aversion. The analysis identifies conditions where the optimal contract is simple and both carrots and sticks are optimal. Our analysis has implications for performance evaluation, corporate compensation structure, prize-linked savings accounts, and the determinants of intrinsic motivation. |
| Keywords: | Contract theory; Skewness Preference; Ambiguity Aversion; Simple Contracts |
| JEL: | D9 D86 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:chu:wpaper:19-02&r=all |
| By: | Alexander Barzykin; Fabrizio Lillo |
| Abstract: | We solve the problem of optimal liquidation with volume weighted average price (VWAP) benchmark when the market impact is linear and transient. Our setting is indeed more general as it considers the case when the trading interval is not necessarily coincident with the benchmark interval: Implementation Shortfall and Target Close execution are shown to be particular cases of our setting. We find explicit solutions in continuous and discrete time considering risk averse investors having a CARA utility function. Finally, we show that, contrary to what is observed for Implementation Shortfall, the optimal VWAP solution contains both buy and sell trades also when the decay kernel is convex. |
| Date: | 2019–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1901.02327&r=all |
| By: | Douadia Bougherara (CEE-M - Centre d'Economie de l'Environnement - Montpellier - FRE2010 - INRA - Institut National de la Recherche Agronomique - UM - Université de Montpellier - CNRS - Centre National de la Recherche Scientifique - Montpellier SupAgro - Institut national d’études supérieures agronomiques de Montpellier); Laurent Piet (SMART - Structures et Marché Agricoles, Ressources et Territoires - INRA - Institut National de la Recherche Agronomique - AGROCAMPUS OUEST) |
| Abstract: | A growing number of studies in finance and economics seek to explain insurance choices using 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 extending 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 increase 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 probability weighting in losses and skewness has a large negative impact on farmer WTP for crop insurance. |
| Keywords: | Crop Insurance,Cumulative Prospect Theory,premium subsidy,skewness |
| Date: | 2018–12–07 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-01947417&r=all |
| By: | Alvarez, Fernando (University of Chicago); Atkeson, Andrew (Federal Reserve Bank of Minneapolis) |
| Abstract: | We develop a new general equilibrium model of asset pricing and asset trading volume in which agents’ motivations to trade arise due to uninsurable idiosyncratic shocks to agents’ risk tolerance. In response to these shocks, agents trade to rebalance their portfolios between risky and riskless assets. We study a positive question — When does trade volume become a pricing factor? — and a normative question — What is the impact of Tobin taxes on asset trading on welfare? In our model, economies in which marketwide risk tolerance is negatively correlated with trade volume have a higher risk premium for aggregate risk. Likewise, for a given economy, we find that assets whose cash flows are concentrated on states with high trading volume have higher prices and lower risk premia. We then show that Tobin taxes on asset trade have a first-order negative impact on ex-ante welfare, i.e., a small subsidy to trade leads to an improvement in ex-ante welfare. Finally, we develop an alternative version of our model in which asset trade arises from uninsurable idiosyncratic shocks to agents’ hedging needs rather than shocks to their risk tolerance. We show that our positive results regarding the relationship between trade volume and asset prices carry through. In contrast, the normative implications of this specification of our model for Tobin taxes or subsidies depend on the specification of agents’ preferences and non-traded endowments. |
| Keywords: | Liquidity; Trade volume; Asset pricing; Tobin taxes |
| JEL: | G12 |
| Date: | 2018–12–31 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedmsr:577&r=all |
| By: | Philippe Mongin (CNRS - Centre National de la Recherche Scientifique); Mikaël Cozic (LIS - Lettres, Idées, Savoir - UPEC UP12 - Université Paris-Est Créteil Val-de-Marne - Paris 12, IHPST - Institut d'Histoire et de Philosophie des Sciences et des Techniques - UP1 - Université Panthéon-Sorbonne - DEC - Département d'Etudes Cognitives - ENS Paris - ENS Paris - École normale supérieure - Paris - CNRS - Centre National de la Recherche Scientifique) |
| Abstract: | Nudge is a concept of policy intervention that originates in Thaler and Sunstein's (2008) popular eponymous book. Following their own hints, we distinguish three properties of nudge interventions: they redirect individual choices by only slightly altering choice conditions (here nudge 1), they use rationality failures instrumentally (here nudge 2), and they alleviate the unfavourable effects of these failures (here nudge 3). We explore each property in semantic detail and show that no entailment relation holds between them. This calls into question the theoretical unity of nudge, as intended by Thaler and Sunstein and most followers. We eventually recommend pursuing each property separately, both in policy research and at the foundational level. We particularly emphasize the need of reconsidering the respective roles of decision theory and behavioural economics to delineate nudge 2 correctly. The paper differs from most of the literature in focusing on the definitional rather than the normative problems of nudge. |
| Keywords: | behavioural economics,Kahneman and Tversky,Thaler and Sunstein,policy analysis,liberal paternalism,nudge,rationality,decision biases,decision theory |
| Date: | 2018 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-01950716&r=all |
| By: | Paolo Delle Site; Karim Kilani (LIRSA - Laboratoire interdisciplinaire de recherche en sciences de l'action - CNAM - Conservatoire National des Arts et Métiers [CNAM]); Valerio Gatta; Edoardo Marcucci; André De Palma (ENS Cachan - École normale supérieure - Cachan) |
| Abstract: | The paper considers models for best, worst and best-worst choice probabilities, that use a single common set of random utilities. Choice probabilities are derived for two distributions of the random terms: i.i.d. extreme value, i.e. Logit, and multivariate normal, i.e. Probit. In Logit, best, worst and best-worst choice probabilities have a closed form. In Probit, worst choice probabilities are simply obtained from best choice probabilities by changing the sign of the systematic utilities. Strict log-concavity of the likelihood, with respect to the coefficients of the systematic utilities, holds, under a mild necessary and sufficient condition of absence of perfect multicollinearity in the matrix of alternative and individual characteristics, for best, worst and best-worst choice probabilities in Logit, and for best and worst choice probabilities in Probit. The assumption of substitutability between best and worst choices is tested with data on mode choice, collected for the assessment of user responses to urban congestion charging policies. The numerical results suggest significantly different preferences between best and worst choices, even accounting for scale differences, in both Logit and Probit models. Worst choice data exhibit coefficient attenuation, less pronounced in Probit than in Logit, and higher mean values of travel time savings with larger confidence intervals. |
| Keywords: | Logit,Probit,Congestion charge,Strict log-concavity,Random utility model,Best-worst choices |
| Date: | 2018–12–13 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-01953581&r=all |
| By: | Christoph Engel; Alexandra Fedorets; Olga Gorelkina |
| Abstract: | Individuals often have to decide to which degree of risk they want to expose others, or how much risk to accept if their choice has an externality on third parties. One typical application is a household. We run an experiment in the German Socio-Economic Panel with two members from 494 households. Participants have a good estimate of each other’s risk preferences, even if not explicitly informed. They do not simply match this preference when deciding on behalf of the other household member, but shy away from exposing others to risk. We model the situation, and we find four distinct types of individuals, and two distinct types of households. |
| Keywords: | risk preference, household, reticence to expose others to risk, trade-off between individual and foreign risk preference |
| JEL: | C45 D13 D81 D91 |
| Date: | 2018 |
| URL: | http://d.repec.org/n?u=RePEc:diw:diwsop:diw_sp1000&r=all |
| By: | Pablo Schenone |
| Abstract: | We propose a decision-theoretic model akin to Savage (1972) that is useful for defining causal effects. Within this framework, we define what it means for a decision maker (DM) to act as if the relation between the two variables is causal. Next, we provide axioms on preferences and show that these axioms are equivalent to the existence of a (unique) Directed Acyclic Graph (DAG) that represents the DM's preference. The notion of representation has two components: the graph factorizes the conditional independence properties of the DM's subjective beliefs, and arrows point from cause to effect. Finally, we explore the connection between our representation and models used in the statistical causality literature (for example, Pearl (1995)). |
| Date: | 2018–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1812.07414&r=all |
| By: | Markus Dertwinkel-Kalt; Mats Köster |
| Abstract: | Whether people seek or avoid risks on gambling, insurance, asset, or labor markets crucially depends on the skewness of the underlying probability distribution. In fact, people typically seek positively skewed risks and avoid negatively skewed risks. We show that salience theory of choice under risk can explain this preference for positive skewness, because unlikely, but outstanding payoffs attract attention. In contrast to alternative models, however, salience theory predicts that choices under risk not only depend on the absolute skewness of the available options, but also on how skewed these options appear to be relative to each other. We exploit this fact to derive novel, experimentally testable predictions that are unique to the salience model and that we find support for in two laboratory experiments. We thereby argue that skewness preferences—typically attributed to cumulative prospect theory—are more naturally accommodated by salience theory. |
| Keywords: | salience theory, cumulative prospect theory, skewness preferences |
| JEL: | D81 |
| Date: | 2018 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_7416&r=all |
| By: | Ortega, Josué |
| Abstract: | I study the problem of allocating objects among agents without using money. Agents can receive several objects and have dichotomous preferences, meaning that they either consider objects to be acceptable or not. In this set-up, the egalitarian solution is more appealing than the competitive equilibrium with equal incomes because it is Lorenz dominant, unique in utilities, and group strategy- proof. Both solutions are disjoint. |
| Keywords: | dichotomous preferences,multi-unit assignment,Lorenz dominance,competitive equilibrium with equal incomes |
| JEL: | C78 D73 |
| Date: | 2018 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:zewdip:18052&r=all |