nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2019‒03‒11
seventeen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Procedural Mixture Spaces By Rommeswinkel, Hendrik
  2. Limit Orders under Knightian Uncertainty By Michael Greinecker; Christoph Kuzmics
  3. The Welfare Cost of Business Cycles at the States’ Levels By Francis W. Ahking
  4. Entrepreneurs’ Attitudes Toward Risk in Micro and Small Enterprises: Evidence from Urban Ethiopia By Abdelkrim Araar; Yesuf Mohammednur Awel; Jonse Bane Boka; Hiywot Menker; Ajebush Shafi; Eleni Abraham Yitbarek; Mulatu Zerihun
  5. Should Portfolio Model Inputs Be Estimated Using One or Two Economic Regimes? By Emmanouil Platanakis; Athanasios Sakkas; Charles Sutcliffe
  6. Model Selection in Utility-Maximizing Binary Prediction By Jiun-Hua Su
  7. Risk aversion, patience and intelligence: Evidence based on macro data By Niklas Potrafke
  8. Measuring Multivariate Risk Preferences in the Health Domain By Arthur Attema; Olivier L’haridon; Gijs Van de Kuilen
  9. Optimal Learning and Ellsberg’s Urns By Larry G. Epstein; Shaolin Ji
  10. Perceptions of Inequality and Redistribution: A Note By Roberto Iacono; Marco Ranaldi
  11. Rationality and Capitalist Schooling By Lambert, Thomas
  12. Optimal Investment-Consumption-Insurance with Durable and Perishable Consumption Goods in a Jump Diffusion Market By Jin Sun; Ryle S. Perera; Pavel V. Shevchenko
  13. Non-Parametric Robust Model Risk Measurement with Path-Dependent Loss Functions By Yu Feng
  14. Monetary Policy in a Small Open Economy with Non-Separable Government Spending By Troug, Haytem
  15. Partial Ex-Post Verifiability and Unique Implementation of Social Choice Functions By Hitoshi Matsushima
  16. A critique of momentum anomalies By de Oliveira Souza, Thiago
  17. Bitcoin and hyperdeflation : an optimizing monetary approach By Sokic, Alexandre

  1. By: Rommeswinkel, Hendrik
    Abstract: This paper provides a representation theorem for procedural mixture spaces. Procedural mixture spaces are mixture spaces in which it is not necessarily true that a mixture of two identical elements yields the same element. Under the remaining standard assumptions of mixture spaces, the following representation theorem is proven; a rational, independent, and continuous preference relation over mixture spaces can be represented either by expected utility plus the Shannon entropy or by expected utility under probability distortions plus the Renyi entropy. The entropy components can be interpreted as the utility or disutility from resolving the mixture and therefore as a procedural as opposed to consequentialist value.
    Keywords: Risk, decision theory, procedural value, lotteries, mixture spaces
    JEL: D01 D03 D81
    Date: 2019–03–05
  2. By: Michael Greinecker (University of Graz, Austria); Christoph Kuzmics (University of Graz, Austria)
    Abstract: Investors who maximize subjective expected utility will generally trade in an asset unless the market price exactly equals the expected return, but few people participate in the stock market. [Dow and da Costa Werlang, Econometrica 1992] show that an ambiguity averse decision maker might abstain from trading in an asset for a wide interval of prices and use this fact to explain the lack of participation in the stock market. We show that when markets operate via limit orders, all investment behavior will be observationally equivalent to maximizing subjective expected utility; ambiguity aversion has no additional explanatory power.
    Keywords: Ambiguity; Knightian uncertainty; Dominance; Stock market participation; Limit orders
    JEL: D81 D83 G11 G12
    Date: 2019–03
  3. By: Francis W. Ahking (University of Connecticut)
    Abstract: ucas (1987, 2003) calculates the potential welfare gains to stabilization of business cycles to be surprisingly small. Welfare gain is measured by a compensation parameter which makes a household indifferent between a deterministic lifetime stream and a compensated, risky lifetime stream of consumption. Using a constant relative risk aversion utility function and a coefficient of risk aversion of one, Lucas calculates that the welfare gain in real per capita consumption is in the order of one-twentieth of 1 percent. This is equivalent to an increase of about $18.33 in real per capita consumption per year for 1947 – 2001, stated in 2016 dollars. The main focus of this paper is to examine the welfare cost of business cycles for the 50 states using the same preference function as Lucas (1987, 2003). To our knowledge, this is the first paper that examines the welfare cost of business cycles at the state level. Our results support the findings of Lucas (1987, 2003) and Otrok (2001) that further welfare gain from stabilization of business cycles are very small, ranging from one-eighth of 1 percent for Wyoming to one-forty-fifth of 1 percent for Iowa. Further results from additional analysis also suggest that welfare cost of business cycles varies considerably across regions of the country.
    Keywords: welfare gain, stabilization policy, state business cycles
    JEL: E32 E63 H80
    Date: 2019–03
  4. By: Abdelkrim Araar; Yesuf Mohammednur Awel; Jonse Bane Boka; Hiywot Menker; Ajebush Shafi; Eleni Abraham Yitbarek; Mulatu Zerihun
    Abstract: The attitudes toward risk of women and men entrepreneurs in micro- and small enterprises (MSEs) are analyzed, and the factors that influence attitude toward risk of MSE owners are investigated. The empirical analysis first uses the moment-based approach proposed by Antle (1987) to estimate the risk preferences of men and women entrepreneurs. Second, a regression model is employed to understand the correlates of attitude toward risk and to decompose gender differences in risk aversion using the Oaxaca-Blinder technique. The results clearly indicate that MSE entrepreneurs are risk-averse with a relative risk premium of 1.5%. Women entrepreneurs are slightly more risk-averse than are men entrepreneurs. Regression estimates show that entrepreneurs’ attitude toward risk is significantly correlated with age and experience, marital status, education level, financial literacy, wealth, sector, and business type. The gender difference in risk aversion is significantly explained by the predictor variables while the unexplained component is insignificant. This suggests that gender differences in risk preference are the result of disparities in socioeconomic factors rather than of biology.
    Keywords: risk aversion, gender, micro- and small enterprises
    JEL: D14 J16 M21
    Date: 2019
  5. By: Emmanouil Platanakis (School of Management, University of Bath); Athanasios Sakkas (Southampton Business School, University of Southampton); Charles Sutcliffe (ICMA Centre, Henley Business School, University of Reading)
    Abstract: Estimation errors in the inputs are the main problem when applying portfolio analysis. Markov regime switching models are used to reduce these errors, but they do not always improve out-of-sample portfolio performance. We investigate the levels of transaction costs and risk aversion below which the use of two regimes is superior to one regime for an investor with a CRRA utility function, allowing for skewed and kurtic returns. Our results suggest that, due to differences in risk and transactions costs, most retail investors should use one regime models, while investment banks should use two regime models.
    Keywords: finance, portfolio theory, regime shifting, transaction costs, risk aversion, constant relative risk aversion
    JEL: G11
    Date: 2017–09
  6. By: Jiun-Hua Su
    Abstract: The semiparametric maximum utility estimation proposed by Elliott and Lieli (2013) can be viewed as cost-sensitive binary classification; thus, its in-sample overfitting issue is similar to that of perceptron learning in the machine learning literature. Based on structural risk minimization, a utility-maximizing prediction rule (UMPR) is constructed to alleviate the in-sample overfitting of the maximum utility estimation. We establish non-asymptotic upper bounds on the difference between the maximal expected utility and the generalized expected utility of the UMPR. Simulation results show that the UMPR with an appropriate data-dependent penalty outweighs some common estimators in binary classification if the conditional probability of the binary outcome is misspecified, or a decision maker's preference is ignored.
    Date: 2019–03
  7. By: Niklas Potrafke
    Abstract: Using the new macro data on risk aversion and patience by Falk et al. (2018), I show that risk aversion and patience are related to intelligence: high-IQ populations are more patient and more risk averse than low-IQ populations. The correlation between patience and intelligence corroborates previous results based on micro data. Intelligent people tend to be patient because they have long time horizons. The correlation between risk aversion and intelligence supports new micro data studies based on dynamically optimized sequential experimentation (Chapman et al. 2018).
    Keywords: Risk aversion, patience, intelligence
    JEL: D00 D81 D90
    Date: 2019
  8. By: Arthur Attema (Erasmus School of Economics - Erasmus University Rotterdam); Olivier L’haridon (CREM - Centre de recherche en économie et management - UNICAEN - Université de Caen Normandie - NU - Normandie Université - UR1 - Université de Rennes 1 - UNIV-RENNES - Université de Rennes - CNRS - Centre National de la Recherche Scientifique); Gijs Van de Kuilen (TiSEM - Tilburg School of Economics and Management - Tilburg University [Netherlands])
    Abstract: We investigate univariate and multivariate risk preferences for health (longevity) and wealth. We measure attitudes toward correlation and attitudes toward higher order dependence structures such as cross-prudence and cross-temperance, making use of the risk apportionment technique proposed by Eeckhoudt et al. (2007). For multivariate gains, we find correlation aversion and cross-prudence in longevity and wealth. For losses, we observe correlation seeking and cross-imprudence. We do not find clear evidence for cross-temperance. Our results indicate that longevity and wealth are considered to be substitutes for gains, but not for losses. Second, univariate (higher order) risk preferences are comparable for longevity and wealth, although somewhat closer to linearity for wealth. Third, we find evidence that attitudes toward dependence structures in the health domain are sign-dependent.
    Keywords: multivariate risk attitudes,health,prudence,temperance
    Date: 2019–03
  9. By: Larry G. Epstein (Department of Economics, Boston University); Shaolin Ji (Institute of Financial Studies, Shandong University)
    Abstract: We consider the dynamics of learning under ambiguity when learning is costly and is chosen optimally. The setting is Ellsberg’s two-urn thought experiment modified by allowing the agent to postpone her choice between bets so that she can learn about the composition of the ambiguous urn. Signals are modeled by a diffusion process whose drift is equal to the true bias of the ambiguous urn and they are observed at a constant cost per unit time. The resulting optimal stopping problem is solved and the effect of ambiguity on the extent of learning is determined. It is shown that rejection of learning opportunities can be optimal for an ambiguity averse agent even given a small cost.
    Keywords: ambiguity, learning, partial information, optimal stopping, drift-diffusion model
    Date: 2017–08
  10. By: Roberto Iacono (NTNU - Norwegian University of Science and Technology [Trondheim]); Marco Ranaldi (UP1 - Université Panthéon-Sorbonne, PSE - Paris School of Economics)
    Abstract: This paper shows that perceptions of inequality are a key factor in the formation of preferences for redistribution and thereby in the determination of the equilibrium redistribution level. We build on the novel stylized facts provided by the recent empirical and experimental literature on perceptions of income inequality. In brief, the emerging consensus is that agents incorrectly estimate the shape of the income distribution because of limited information. Agents with income above the mean believe they are poorer than they actually are, and agents with income below the mean believe themselves to be richer. We revisit the standard framework on the political economy of redistribution and extend it in two ways. First, we assume a more general two-sided inequality aversion. Second, we incorporate perceptions of income inequality in the model. We show analytically that the equilibrium redistribution level is crucially determined by the interplay between the information treatment correcting the bias in perceptions of inequality and fairness considerations specified by the degree of inequality aversion. By doing this, we add (biased) perceptions of inequality to the list of potential factors explaining why, notwithstanding high levels of inequality, in many countries, an increase in the desire for redistribution has not been observed.
    Keywords: Meltzer-Richard Model,Perceived Inequality,Inequality Aversion,Redistributive Preferences
    Date: 2019–01
  11. By: Lambert, Thomas
    Abstract: In the field of philosophy of mind, the concepts of rational behavior, rational choice theory, and instrumental rationality (the “practical reasoning” version of rationality) are important in trying to make statements and conclusions about human thinking and behavior in general. Rational choice theory is also considered a normative but not a descriptive or positive theory. Much of economic theory is based on the principle that economic agents usually or always behave rationally in maximizing the benefits and/or minimizing the costs of their decisions. Developments in behavioral economics over the last several decades have begun to question this principle with much of the questioning about rationality and rational behavior centering on whether individuals can correctly and adequately assess probabilities and risk/reward. The inability to correctly assess risk/reward limits rational behavior and can yield sub-optimal outcomes for economic agents. This exploratory paper examines the linkages between schooling in a capitalist society and limits on rationality in a monopoly capital economic system.
    Keywords: behavioral economics, capitalist schooling, monopoly capital, rationality, rational choice
    JEL: B51 I24
    Date: 2019–03–05
  12. By: Jin Sun; Ryle S. Perera; Pavel V. Shevchenko
    Abstract: We investigate an optimal investment-consumption and optimal level of insurance on durable consumption goods with a positive loading in a continuous-time economy. We assume that the economic agent invests in the financial market and in durable as well as perishable consumption goods to derive utilities from consumption over time in a jump-diffusion market. Assuming that the financial assets and durable consumption goods can be traded without transaction costs, we provide a semi-explicit solution for the optimal insurance coverage for durable goods and financial asset. With transaction costs for trading the durable good proportional to the total value of the durable good, we formulate the agent's optimization problem as a combined stochastic and impulse control problem, with an implicit intervention value function. We solve this problem numerically using stopping time iteration, and analyze the numerical results using illustrative examples.
    Date: 2019–03
  13. By: Yu Feng
    Abstract: Understanding and measuring model risk is important to financial practitioners. However, there lacks a non-parametric approach to model risk quantification in a dynamic setting and with path-dependent losses. We propose a complete theory generalizing the relative-entropic approach by Glasserman and Xu to the dynamic case under any $f$-divergence. It provides an unified treatment for measuring both the worst-case risk and the $f$-divergence budget that originate from the model uncertainty of an underlying state process.
    Date: 2019–03
  14. By: Troug, Haytem
    Abstract: To show how fiscal policy affects the transmission mechanism of monetary policy, we extend a standard new Keynesian model for a small open economy to allow for the presence of non-separable government consumption in the utility function. We show how monetary policy should optimally respond to demand and supply shocks when the government sector is incorporated into the model. The introduction of government consumption affects the transmission of monetary policy. When government consumption has a crowding in effect on private consumption, it will dampen the transmission mechanism of monetary policy, and vice versa. Nevertheless, the degree of openness will minimise the effect of the introduction of government consumption in a non-separable form. Data for 35 OECD countries empirically support these findings, and the empirical results are robust to the zero lower bound period. The theoretical model also shows that, once we model the rest of the world economy, domestic government consumption and foreign government consumption will have opposing effects on private consumption, which contradicts with the existing literature.
    Keywords: New Keynesian models, Business Cycle, Monetary Policy, Open Economy Macroeconomics, Joint Analysis of Fiscal and Monetary Policy.
    JEL: E12 E32 E52 E63 F41
    Date: 2019–03–02
  15. By: Hitoshi Matsushima (University of Tokyo)
    Abstract: This study investigates the unique implementation of a social choice function in iterative dominance in the ex-post term. We assume partial ex-post verifiability; that is, after determining an allocation, the central planner can only observe partial information about the state as verifiable. We demonstrate a condition of the state space, termed “full detection,†under which any social choice function is uniquely implementable even if the range of the players’ lies, which the ex-post verifiable information directly detects, is quite narrow. To prove this, we construct a dynamic mechanism according to which each player announces his (or her) private signal before the other players observe this signal at an earlier stage, and each player also announces the state at a later stage. In this construction, we can impose several severe restrictions, such as boundedness, permission of only tiny transfers off the equilibrium path, and no permission of transfers on the equilibrium path. This study does not assume either expected utility or quasi-linearity.
    Date: 2019–02
  16. By: de Oliveira Souza, Thiago (Department of Business and Economics)
    Abstract: This paper offers theoretical, empirical, and simulated evidence that momentum regularities in asset prices are not anomalies. Within a general, frictionless, rational expectations, risk-based asset pricing framework, riskier assets tend to be in the loser portfolios after (large) increases in the price of risk. Hence, the risk of momentum portfolios usually decreases with the prevailing price of risk, and their risk premiums are approximately negative quadratic functions of the price of risk (and the market premium) theoretically truncated at zero. The best linear (CAPM) function describing this relation unconditionally has exactly the negative slope and positive intercept documented empirically.
    Keywords: Momentum; risk; puzzle; ranking; conditional
    JEL: G11 G12 G14
    Date: 2019–02–20
  17. By: Sokic, Alexandre
    Abstract: This paper is deeply motivated by the need to explore the impressive Bitcoin price development by addressing Bitcoin as money in its essential attribute as a medium of exchange. We adopt a monetary economics viewpoint and resort to a representative agent modelling strategy within a money-in-the-utility function (MIUF) framework. First, we show that the impressive Bitcoin price development observed since its inception can be interpreted as a hyperdeflation when we focus on Bitcoin role as a medium of exchange. Second, we show that specific monetary features of Bitcoin, its asymptotical fixed nominal stock and divisibility down to eight decimal places, account for a strong possibility of speculative hyperdeflationary paths. It is shown that those paths are fully consistent with the medium of exchange monetary role of Bitcoin and the representative agent optimizing behavior.
    Keywords: Cryptocurrencies, Bitcoin, hyperdeflation, medium of exchange
    JEL: E31 E41 E42
    Date: 2018–11

This nep-upt issue is ©2019 by Alexander Harin. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.