
on Utility Models and Prospect Theory 
Issue of 2019‒02‒18
nine papers chosen by 
By:  Nikolay R. Rachev (Department of General, Experimental, Developmental, and Health Psychology, Sofia University “St. Kliment Ohridski”) 
Abstract:  Prospect theory accounted for the framing effect by assuming an automatic translation of the problem content into expected utilities and a passive acceptance of the externally provided frame regardless of problem content. The size of the framing effect in the famous Asian Disease problem initially suggested that these assumptions are met but subsequent research showed otherwise. In a dataset collected during regular class sessions among Bulgarian students, a framing effect was found for monetary problems but not for the Disease problem. These results are consistent with previous findings by the author and add to the view that a topdown and domainspecific approach might be a necessary complication when one is aiming to account for the psychological processes during risky choices. 
Keywords:  Prospect Theory, Framing, Asian Disease Problem, Content Effects, TopDown Processing. 
JEL:  D91 D81 J17 
Date:  2019–02 
URL:  http://d.repec.org/n?u=RePEc:sko:wpaper:bep201904&r=all 
By:  Victor Stango; Jonathan Zinman 
Abstract:  Can a behavioral sufficient statistic empirically capture crossconsumer variation in behavioral tendencies and help identify whether behavioral biases, taken together, are linked to material consumer welfare losses? Our answer is yes. We construct simple consumerlevel behavioral sufficient statistics—“Bcounts”—by eliciting seventeen potential sources of behavioral biases per person, in a nationally representative panel, in two separate rounds nearly three years apart. Bcounts aggregate information on behavioral biases withinperson. Nearly all consumers exhibit multiple biases, in patterns assumed by behavioral sufficient statistic models (a la Chetty), and with substantial variation across people. Bcounts are stable withinconsumer over time, and that stability helps to address measurement error when using Bcounts to model the relationship between biases, decision utility, and experienced utility. Conditional on classical inputs—risk aversion and patience, lifecycle factors and other demographics, cognitive and noncognitive skills, and financial resources—Bcounts strongly negatively correlate with both objective and subjective aspects of experienced utility. The results hold in much lowerdimensional models employing “Sparsity Bcounts” based on bias subsets (a la Gabaix) and/or fewer covariates, illuminating lowercost ways to use behavioral sufficient statistics to help capture the combined influence of multiple behavioral biases for a wide range of research questions and applications. 
JEL:  C83 D1 D6 D9 
Date:  2019–02 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:25540&r=all 
By:  Nam Gang Lee (Economic Research Institute, Bank of Korea) 
Abstract:  This paper addresses the link between shocks to productivity trend growth and longrun consumption risk in a production economy model with recursive utility. Quantifying trend growth shocks, I find that persistent fluctuations in trend growth are the key driver of sizable longrun consumption risk. I compare this result to two conventional assumptions on a productivity process: 1) a deterministic trend with a cycle and 2) a random walk with drift. Persistent trend growth shocks generate larger longrun consumption risk than both highly persistent cycle shocks and random walk shocks. As a result, agents in the face of the trend growth shocks tend to save more and demand a higher equity premium. In addition, fluctuations in aggregate productivity growth is largely attributable to movements in trend growth. 
Keywords:  Longrun consumption risk, stochastic trend growth, equity premium, production economy, exact initial Kalman filter 
JEL:  E21 E23 E30 G12 
Date:  2019–01–25 
URL:  http://d.repec.org/n?u=RePEc:bok:wpaper:1904&r=all 
By:  Steffen Meyer; Michaela Pagel 
Abstract:  We use transactionlevel data of portfolio trades and holdings linked to checking, savings, and settlement account transactions and balances to explore how individuals respond to realized capital gains and losses. We exploit plausibly exogenous sales due to mutual fund liquidations for identification. Specifically, we estimate the marginal propensity to reinvest out of one dollar received from a forced liquidation, when the investor either achieved a gain or a loss relative to his or her initial investment. Theoretically, if individuals held optimized portfolios, the marginal propensity to reinvest out of forced sales should be 100%. Individuals should just reinvest all of their liquidity immediately into a fund with similar characteristics. Empirically, individuals reinvest 83% on average if the forced sale resulted in a gain, but only 40% in the event of a loss. If individuals do not reinvest, they keep a share of their newly found liquidity in cash, save it, or consume it. Such differential treatment of gains and losses is inconsistent with active rebalancing or tax considerations, but consistent with mental accounting and the idea that individuals treat realized losses differently than paper losses. We thus provide evidence for realization utility and effects (Barberis and Xiong, 2012; Imas, 2016) and that individuals do not appear to learn rationally from experiences in the stock market (Malmendier and Nagel, 2011; Koudijs and Voth, 2016). 
JEL:  D14 D90 
Date:  2019–02 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:25542&r=all 
By:  Rahul Deb (Institute for Fiscal Studies); Yuichi Kitamura (Institute for Fiscal Studies and Yale University); John Quah (Institute for Fiscal Studies); Jorg Stoye (Institute for Fiscal Studies and Cornell University) 
Abstract:  With the aim of determining the welfare implications of price change in consumption data, we introduce a revealed preference relation over prices. We show that an absence of cycles in this preference relation characterizes a model of demand where consumers tradeoff the utility of consumption against the disutility of expenditure. This model is appropriate whenever a consumer’s demand over a strict subset of all available goods is being analyzed. For the random utility extension of the model, we devise nonparametric statistical procedures for testing and welfare comparisons. The latter requires the development of novel tests of linear hypotheses for partially identified parameters. In doing so, we provide new algorithms for the calculation and statistical inference in nonparametric counterfactual analysis for a general partially identified model. Our applications on national household expenditure data provide support for the model and yield informative bounds concerning welfare rankings across different prices. 
Date:  2018–10–01 
URL:  http://d.repec.org/n?u=RePEc:ifs:cemmap:57/18&r=all 
By:  Sergio A. Pernice 
Abstract:  A fundamental assumption in most of economic modeling is that people maximize their utility subject to a budget constraint. This, as well as many other economic problems, math ematically translate into problems of maximization with constraints. A powerful and widely used method to tackle some of these problems is the method of Lagrange multipliers. Yet, the exposition of such method in standard textbooks is rather formal and utilitarian. In this paper we try to present it emphasising the fundamental intuitions behind the method. 
Keywords:  Maximization with constraints, Lagrange multipliers. 
Date:  2018–12 
URL:  http://d.repec.org/n?u=RePEc:cem:doctra:680&r=all 
By:  Franz Dietrich (CES  Centre d'économie de la Sorbonne  UP1  Université PanthéonSorbonne  CNRS  Centre National de la Recherche Scientifique, PSE  Paris School of Economics); Christian List (LSE  London School of Economics and Political Science) 
Abstract:  Agents are often assumed to have degrees of belief ("credences") and also binary beliefs ("beliefs simpliciter"). How are these related to each other? A muchdiscussed answer asserts that it is rational to believe a proposition if and only if one has a high enough degree of belief in it. But this answer runs into the "lottery paradox": the set of believed propositions may violate the key rationality conditions of consistency and deductive closure. In earlier work, we showed that this problem generalizes: there exists no local function from degrees of belief to binary beliefs that satisfies some minimal conditions of rationality and nontriviality. "Locality" means that the binary belief in each proposition depends only on the degree of belief in that proposition, not on the degrees of belief in others. One might think that the impossibility can be avoided by dropping the assumption that binary beliefs are a function of degrees of belief. We prove that, even if we drop the "functionality" restriction, there still exists no local relation between degrees of belief and binary beliefs that satisfies some minimal conditions. Thus functionality is not the source of the impossibility; its source is the condition of locality. If there is any nontrivial relation between degrees of belief and binary beliefs at all, it must be a "holistic" one. We explore several concrete forms this "holistic" relation could take. 
Abstract:  Il est souvent supposé que des acteurs ont à la fois des degrés de croyance (des « probabilités subjectives ») et des croyances binaires (« croyances » simplement). Comment sontils reliés ? Une réponse discutée est qu'il faut croire une proposition si et seulement si l'on a une probabilité subjective suffisamment haute en cette proposition. Mais cette réponse amène au paradoxe de loterie ("lottery paradox") : l'ensemble des propositions crues peut violer deux conditions de rationalité centrales, la cohérence et la clôture déductive. Dans un travail antérieur nous avions généralisé ce paradoxe : il n'existe aucune fonction de binarisation des croyances qui soit "locale" et satisfait des conditions de rationalité et de non trivialité. On aurait pu croire que cette impossibilité puisse être évitée en enlevant la restriction que les croyances binaires sont une fonction des probabilités subjectives. Dans ce papier nous généralisons l'impossibilité en supprimant la restriction de fonctionnalité, c'estàdire en partant non pas d'une fonction de binarisation mais d'une relation quelconque entre les deux types de croyances. Ceci montre que la fonctionnalité n'est pas le source du paradoxe de loterie. La seule source en est la « localité ». Nous explorons une série de relations non locales (holistes) entre les deux types de croyances. 
Keywords:  binary beliefs (yes/no),subjective probabilities,construction of binary beliefs from subjective probabilities,impossibility theorem,croyances binaires (oui/non),probabilités subjectives,construction de croyances binaires à partir des probabilités subjectives,théorème d'impossibilité 
Date:  2019–01 
URL:  http://d.repec.org/n?u=RePEc:hal:cesptp:halshs01999527&r=all 
By:  Christophe Muller (AMSE  AixMarseille Sciences Economiques  EHESS  École des hautes études en sciences sociales  AMU  Aix Marseille Université  ECM  Ecole Centrale de Marseille  CNRS  Centre National de la Recherche Scientifique) 
Abstract:  Since the seminal paper of Atkinson and Bourguignon (1982), little decisive progress has been achieved in developing empirically efficient stochastic dominance criteria for multidimensional social welfare analysis. By proposing new axioms of 'Social Shock Sharing', this paper provides new intuitive justifications to imposing sign restrictions on partial derivatives of individual von NeumannMorgenstern utility functions. These new breakthrough findings are exploited to derive necessary and sufficient stochastic dominance criteria for multidimensional social welfare comparisons, up to the sixth order, at least. Equivalent results are derived in terms of multidimensional poverty conditions. Empirically powerful discriminatory criteria are obtained by combining all social shock sharing axioms up to some high order and by deriving a dimension reduction property. An application to Egypt at the beginning of the XXIst century demonstrates the practical substantial gain in discriminating power of the approach by revealing a unambiguous continual improvement in bivariate incomeeducation social welfare over the studied period. 
Keywords:  multidimensional welfare,stochastic dominance,temperance,risk sharing 
Date:  2019–01 
URL:  http://d.repec.org/n?u=RePEc:hal:wpaper:halshs02005735&r=all 
By:  Cormac O'Dea (Institute for Fiscal Studies); David Sturrock (Institute for Fiscal Studies and Institute for Fiscal Studies) 
Abstract:  The "annuity puzzle" refers to the fact that annuities are rarely purchased despite the longevity insurance they provide. Most explanations for this puzzle assume that individuals have accurate expectations about their future survival. We provide evidence that individuals misperceive their mortality risk, and study the demand for annuities in a setting where annuities are priced by insurers on the basis of objectivelymeasured survival probabilities but in which individuals make purchasing decisions based on their own subjective survival probabilities. Subjective expectations have the capacity to explain signi cant rates of nonannuitization, yielding a quantitatively important explanation for the annuities puzzle. 
Keywords:  Annuity Puzzle, Subjective Expectations, Survival Probabilities 
Date:  2019–01–17 
URL:  http://d.repec.org/n?u=RePEc:ifs:ifsewp:19/02&r=all 