nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2019‒05‒27
eighteen papers chosen by

  1. Discounting the Future: on Climate Change, Ambiguity Aversion and Epstein-Zin Preferences By Stan Olijslagers; Sweder van Wijnbergen
  2. Equity Risk Premium and Time Horizon: what do the French secular data say ? By Georges Prat; David Le Bris
  3. From aggregate betting data to individual risk preferences By Pierre-Andre Chiappori; Bernard Salanie; Francois Salanie; Amit Gandhi
  4. Public good provision financed by nonlinear income tax under reduction of envy By Takuya Obara; Shuichi Tsugawa
  5. Spite vs. risk: explaining overbidding By Oliver Kirchkamp; Wladislaw Mill
  6. A short note on the rationality of the false consensus effect By Vanberg, Christoph
  7. Optimal Stopping Time, Consumption, Labour, and Portfolio Decision for a Pension Scheme By Francesco Menoncin; Sergio Vergalli
  8. Axiomatizations of the Shapley Value for Upstream Responsibility Games By Pintér, Miklós; Radványi, Anna
  9. The Economic Preferences of Cooperative Managers By Alves, Guillermo; Blanchard, Pablo; Burdín, Gabriel; Chávez, Mariana; Dean, Andres
  10. A Perfectly Robust Approach to Multiperiod Matching Problems By Kotowski, Maciej
  11. Distributional preferences in larger groups: Keeping up with the Joneses and keeping track of the tails By Raymond Fisman; Ilyana Kiziemko; Silvia Vannutelli
  12. Simplicity Creates Inequity: Implications for Fairness, Stereotypes, and Interpretability By Jon Kleinberg; Sendhil Mullainathan
  13. Risk aversion, prudence and temperance: an experiment in gain and loss By Marielle Brunette; Julien Jacob
  14. Identity and Redistribution: Theory and Evidence By Sanjit Dhami; Emma Manifold; Ali al-Nowaihi
  15. Macro-finance and factor timing: Time-varying factor risk and price of risk premiums By de Oliveira Souza, Thiago
  16. Online Appendix to "The role of risk aversion in a sovereign default model of polarization and political instability" By Yasin Kursat Onder; Enes Sunel
  17. Sovereign Debt Restructurings: Delays in Renegotiations and Risk Averse Creditors By Tamon Asonuma; Hyungseok Joo
  18. Unhedgeable Inflation Risk within Pension Schemes By Beetsma, Roel; Chen, Damiaan; van Wijnbergen, Sweder

  1. By: Stan Olijslagers (University of Amsterdam); Sweder van Wijnbergen (University of Amsterdam)
    Abstract: We focus on the effect of preference specifications on the current day valuation of future outcomes. Specifically, we analyze the effect of risk aversion, ambiguity aversion and the elasticity of intertemporal substitution on the willingness to pay to avoid climate change risk. The first part of the paper analyzes a general disaster (jump) risk model with a constant arrival rate of disasters. This provides useful intuition in how preferences influence valuation of long-term risk. The second part of the paper extends this model with a climate model and a temperature dependent arrival rate. Since the model yields closed form solutions up to solving an integral, our model does not suffer from the curse of dimensionality of numerical IAMs with several state variables. Introducing Epstein-Zin preferences with an elasticity of substitution higher than one and ambiguity aversion leads to much larger estimates of the social cost of carbon than obtained under power utility. The dominant parameters are the risk aversion coefficient and the elasticity of intertemporal substitution. Ambiguity aversion is of second order importance.
    Keywords: Social Cost of Carbon, Ambiguity Aversion, Epstein-Zin preferences, Stochastic Differential Utility, Climate Change
    JEL: Q51 Q54 G12 G13
    Date: 2019–04–24
  2. By: Georges Prat; David Le Bris
    Abstract: We consider a representative investor whose wealth is shared between a replica of the equity market portfolio and the riskless asset, and who maximizes the expected utility of their future wealth. For a given time-horizon, the solution of this program equalizes the required risk premium to the product of price of risk by the expected variance of stock returns. As a tentative to capture exogenous disturbing effects, the term spread of interest rates and US equity risk premia complement this relationship. Two traditional horizons are considered: the one-period-ahead horizon characterizing the ‘short-term’ investor and the infinite-time horizon characterizing the ‘long-term’ investor. For each horizon, expected returns are represented by mixing the three traditional adaptive, extrapolative and regressive process, expected variance is represented by a GARCH process, while the unobservable time-varying price of risk is estimated according to the Kalman filter methodology. Based on annual French data established by Le Bris and Hautcoeur (2010), large disparities in the dynamics of the short- and long term observed premia are evidenced from 1872 to 2018, while, due to risky arbitrage and transaction costs, the observed premia appeared to gradually converge towards their required values. Overall, although the French market had experienced very strong historical shocks, our model provides both measurements and explanations of French short- and long-term risk premia and so shed some additional light on the existence of a time-varying term structure of equity risk premia. Despite differences, results on the French market are rather in accordance with those by Prat (2013) based on US secular data.
    Keywords: equity risk premium, time horizon, France
    JEL: D81 D84 E44 G11 G12
    Date: 2019
  3. By: Pierre-Andre Chiappori (Department of Economics - Universität Mannheim [Mannheim]); Bernard Salanie (Department of Economics - Universität Mannheim [Mannheim]); Francois Salanie (TSE - Toulouse School of Economics - UT1 - Université Toulouse 1 Capitole - CNRS - Centre National de la Recherche Scientifique - INRA - Institut National de la Recherche Agronomique - EHESS - École des hautes études en sciences sociales); Amit Gandhi (Department of Economics - Universität Mannheim [Mannheim])
    Abstract: We show that even in the absence of data on individual decisions, the distribution of individual attitudes towards risk can be identified from the aggregate conditions that characterize equilibrium on markets for risky assets. Taking parimutuel horse races as a textbook model of contingent markets, we allow for heterogeneous bettors with very general risk preferences, including non-expected utility. Under a standard single-crossing condition on preferences, we identify the distribution of preferences among the population of bettors and we derive testable implications. We estimate the model on data from U.S. races. Specifications based on expected utility fit the data very poorly. Our results stress the crucial importance of nonlinear probability weighting. They also suggest that several dimensions of heterogeneity may be at work.
    Keywords: Identification,revealed preferences,attitudes towards risk
    Date: 2019
  4. By: Takuya Obara; Shuichi Tsugawa
    Abstract: We examine optimal taxation and public good provision by a government that considers reduction of envy as a constraint. We adopt the extended envy-freeness proposed by Diamantaras and Thomson (1990), called λ-equitability. We derive the modified Samuelson rule under an optimal nonlinear income tax and show, using a constant elasticity of substitution utility function, that the direction of distorting the original Samuelson rule to relax the λ envy-free constraint is crucially determined by the elasticity of substitution. Furthermore, we numerically show that the optimal level of provision increases (decreases) in the degree of envy-freeness when the original Samuelson rule is upwardly (downwardly) distorted.
    Date: 2019–02
  5. By: Oliver Kirchkamp; Wladislaw Mill
    Abstract: In this paper we use an experiment to compare a theory of risk aversion and a theory of spite as an explanation for overbidding in auctions. As a workhorse we use the second-price all-pay and the first-price winner-pay auction. Both risk and spite can be used to rationalize deviations from risk neutral equilibrium bids in auctions. We exploit that equilibrium predictions in the second-price all-pay auctions for spiteful preferences are different than those for risk averse preferences. Indeed, we find that spite is a more convincing explanation for bidding behavior for the second-price all-pay auction. Not only can spite rationalize observed bids, also our measure for spite is consistent with observed bids.
    Keywords: auction, overbidding, spite, risk, experiment
    JEL: C91 C72 D44 D91
    Date: 2019
  6. By: Vanberg, Christoph
    Abstract: In experiments which measure subjects’ beliefs, both beliefs about others’ behavior and beliefs about others’ beliefs, are often correlated with a subject’s own choices. Such phenomena have been interpreted as evidence of a causal relationship between beliefs and behavior. An alternative explanation attributes them to what psychologists refer to as a ‘false consensus effect’. It is my impression that the latter explanation is often prematurely dismissed because it is thought to be based on an implausible psychological bias. The goal of this note is to show that the false consensus effect does not rely on such a bias. I demonstrate that rational belief formation implies a correlation of behavior and beliefs of all orders whenever behaviorally relevant traits are drawn from an unknown common distribution. Thus, if we assume that subjects rationally update beliefs, correlations of beliefs and behavior cannot support a causal relationship.
    Keywords: beliefs; behavioral economics; experimental economics
    Date: 2019–05–09
  7. By: Francesco Menoncin (Università degli Studi di Brescia); Sergio Vergalli (Università degli Studi di Brescia)
    Abstract: In this work we solve in a closed form the problem of an agent who wants to optimise the inter-temporal utility of both his consumption and leisure by choosing: (i) the optimal inter-temporal consumption, (ii) the optimal inter-temporal labour supply, (iii) the optimal share of wealth to invest in a risky asset, and (iv) the optimal retirement age. The wage of the agent is assumed to be stochastic and correlated with the risky asset on the financial market. The problem is split into two sub-problems: the optimal consumption, labour, and portfolio problem is solved first, and then the optimal stopping time is approached. The martingale method is used for the first problem, and it allows to solve it for any value of the stopping time which is just considered as a stochastic variable. The problem of the agent is solved by assuming that after retirement he received a utility that is proportional to the remaining human capital. Finally, a numerical simulation is presented for showing the behaviour over time of the optimal solution.
    Keywords: ptimal Stopping Time, Retirement Choice, Labour Supply, Asset Allocation, Mortality Risk
    JEL: C61 G11 J22
    Date: 2019–05
  8. By: Pintér, Miklós; Radványi, Anna
    Abstract: In this paper the problem of sharing the cost of emission in supply chains are considered. We focus on allocation problems that can be described by rooted trees, called cost-tree problems, and on the induced transferable utility cooperative games, called upstream responsibility games (Gopalakrishnan et al., 2017). The formal notion of upstream responsibility games is introduced, and the characterization of the class of these games is provided. The Shapley value (Shapley, 1953) is probably the most popular value for transferable utility cooperative games. In Radvanyi (2018b) we showed that Shapley's (Shapley, 1953) and Young's (Young, 1985) axiomatizations of the Shapley value are valid on the class of upstream responsibility games. According to Gopalakrishnan et al. (2017) we introduce some pollution related properties and we relate them to the TU games terminologies.
    Keywords: Upstream responsibility games, Cost sharing, Emission, Supply chain, Shapley value, Rooted tree, Axiomatization of the Shapley value
    JEL: C71
    Date: 2019–05–20
  9. By: Alves, Guillermo (Development Bank of Latin America); Blanchard, Pablo (IECON, Universidad de la República); Burdín, Gabriel (Leeds University Business School); Chávez, Mariana (IECON, Universidad de la República); Dean, Andres (IECON, Universidad de la República)
    Abstract: A growing body of research has been investigating the role of management practices and managerial behaviour in conventional private firms and public sector organizations. However, little is known about managers' behavioural profile in noninvestor-owned firms. This paper aims to fill this gap by providing a comprehensive behavioural characterization of managers employed in cooperatives.We gathered incentive-compatible measures of risk preferences, time preferences, reciprocity, altruism, and trust from 196 Uruguayan managers (half of them employed in worker cooperatives) and 92 first-year undergraduate students. To do this, we conducted a high-stakes lab-in-the-field experiment in which participants played a series of online experimental games and made incentivised decisions. The average payoff in the experiment was approximately 2.5 times higher than the average local managerial wage in the private sector. Our key findings are that (1) the fraction of risk loving subjects is lower among co-op managers compared to conventional managers, and (2) co-op managers appear to be more altruistic than their conventional counterparts. Interestingly, we do not observe significant differences between the two groups across other preference domains, such as impatience, trust, and reciprocity.
    Keywords: risk-aversion, time preferences, altruism, reciprocity, trust, lab-in-the-field experiment, managers, cooperatives
    JEL: C90 D81 J54
    Date: 2019–05
  10. By: Kotowski, Maciej (Harvard Kennedy School)
    Abstract: Many two-sided matching situations involve multiperiod interaction. Traditional cooperative solutions, such as stability and the core, often identify unintuitive outcomes (or are empty) when applied to such markets. As an alternative, this study proposes the criterion of perfect alpha-stability. An outcome is perfect alpha-stable if no coalition prefers an alternative assignment in any period that is superior for all plausible market continuations. Behaviorally, the solution combines foresight about the future and a robust evaluation of contemporaneous outcomes. A perfect alpha-stable matching exists, even when preferences exhibit inter-temporal complementarities. A stronger solution, the perfect alpha-core, is also investigated. Extensions to markets with arrivals and departures, transferable utility, and many-to-one assignments are proposed.
    JEL: C71 C78
    Date: 2019–05
  11. By: Raymond Fisman (Boston University); Ilyana Kiziemko; Silvia Vannutelli (Boston University, PhD Candidate)
    Abstract: We study distributional preferences in “large†groups. While most prior experi- ments have focused on exploring attitudes toward inequality in two- or three-person groups, we field a series of experiments via Mechanical Turk in which subjects choose between two income distributions, each with seven (or nine) individuals, with hypo- thetical incomes that aim to approximate the actual distribution of income in the U.S. Our setting thus provides a more direct comparison to the redistributive choices faced by society. Consistent with standard maximin (Rawlsian) preferences, subjects select distributions in which the bottom individual’s income is higher (but show little regard for lower incomes above the bottom ranking). In contrast to standard models, however, we find that subjects select distributions that lower the top individual’s income, but not other high incomes. Finally, we provide tentative evidence of “locally competitive†preferences—in most experimental sessions, subjects select distributions that lower the income of the individual directly above them, while the income of the individual two positions above has little effect on subjects’ decisions. Our findings suggest that the- ories of inequality aversion should be enriched to account for individuals’ aversion to “topmost†and “local†disadvantageous inequality.
    Keywords: Inequality aversion; Envy; Redistribution
    JEL: C91 D63 H23
    Date: 2018–02
  12. By: Jon Kleinberg; Sendhil Mullainathan
    Abstract: Algorithms are increasingly used to aid, or in some cases supplant, human decision-making, particularly for decisions that hinge on predictions. As a result, two additional features in addition to prediction quality have generated interest: (i) to facilitate human interaction and understanding with these algorithms, we desire prediction functions that are in some fashion simple or interpretable; and (ii) because they influence consequential decisions, we also want them to produce equitable allocations. We develop a formal model to explore the relationship between the demands of simplicity and equity. Although the two concepts appear to be motivated by qualitatively distinct goals, we show a fundamental inconsistency between them. Specifically, we formalize a general framework for producing simple prediction functions, and in this framework we establish two basic results. First, every simple prediction function is strictly improvable: there exists a more complex prediction function that is both strictly more efficient and also strictly more equitable. Put another way, using a simple prediction function both reduces utility for disadvantaged groups and reduces overall welfare relative to other options. Second, we show that simple prediction functions necessarily create incentives to use information about individuals' membership in a disadvantaged group—incentives that weren't present before simplification, and that work against these individuals. Thus, simplicity transforms disadvantage into bias against the disadvantaged group. Our results are not only about algorithms but about any process that produces simple models, and as such they connect to the psychology of stereotypes and to an earlier economics literature on statistical discrimination.
    JEL: C54 D8 I30 J7 K00
    Date: 2019–05
  13. By: Marielle Brunette (BETA - Bureau d'Économie Théorique et Appliquée - INRA - Institut National de la Recherche Agronomique - UNISTRA - Université de Strasbourg - UL - Université de Lorraine - CNRS - Centre National de la Recherche Scientifique); Julien Jacob (UNISTRA - Université de Strasbourg)
    Abstract: We characterize the individual's attitude towards risk, prudence and temperance in the gain and loss domains. We analyze the links between the three features of preferences for a given domain and between domains for each feature of preferences. Consequently, the reflection effect, the mixed risk aversion and the risk apportionment, are key concepts of our study. We also display some determinants for risk aversion, prudence and temperance in each domain. To do this, we conducted a lab experiment with students eliciting risk aversion, prudence and temperance in the two domains, and collected information about each subject's characteristics.
    Keywords: risk aversion,prudence,temperance,experiment,correlations,determinant
    Date: 2019
  14. By: Sanjit Dhami; Emma Manifold; Ali al-Nowaihi
    Abstract: We contribute to a growing literature on redistribution and identity. We propose a theoretical model that embeds social identity concerns, as in Akerlof and Kranton (2000), with inequity averse preferences, as in Fehr and Schmidt (1999). We conduct an artefactual ultimatum game experiment with registered members of British political parties for whom both identity and redistribution are salient. The empirical results are as follows. (1) Proposers and responders demonstrate ingroup-favoritism. (2) Proposers exhibit quantitatively stronger social identity effects relative to responders. (3) As redistributive taxes increase, offers by proposers and the minimum acceptable offers of responders (both as a proportion of income) decline by almost the same amount, suggesting a shared understanding that is characteristic of social norms. (4) Subjects experience more disadvantageous inequity from outgroup members relative to ingroup members.
    Keywords: Social identity, prosocial behaviour, ultimatum game, fiscal redistribution, entitlements
    JEL: D01 D03
    Date: 2019–04
  15. By: de Oliveira Souza, Thiago (Department of Business and Economics)
    Abstract: This paper documents empirically that increases in the book-to-market spread predict larger market premiums in sample and larger size, value, and investment premiums (also) out of sample. In addition, increases in the investment (or profitability) spread exclusively predict larger investment (or profitability) premiums. This predictability generates “factor timing” strategies that deliver substantial economic gains out of sample. I argue theoretically that the book-to-market spread is a price of risk proxy, while the investment and profitability spreads are factor risk proxies. The evidence confirms standard theoretical predictions in the macro-finance literature and contradicts the hypothesis of constant factor risks.
    Keywords: Out of sample; factor timing; time-varying risk; macro-finance; Fama and French
    JEL: G11 G12 G14
    Date: 2019–05–13
  16. By: Yasin Kursat Onder; Enes Sunel (Sunel and Sunel)
    Abstract: Online appendix for the Review of Economic Dynamics article
    Date: 2019
  17. By: Tamon Asonuma (International Monetary Fund); Hyungseok Joo (University of Surrey)
    Abstract: Foreign creditors' business cycles influence both the process and the outcome of sovereign debt restructurings. We compile two datasets on creditor committees and chairs and on creditor business and financial cycles at the restructurings, and find that when creditors experience high GDP growth, restructurings are delayed and settled with smaller haircuts. To rationalize these stylized facts, we develop a theoretical model of sovereign debt with multi-round renegotiations between a risk averse sovereign debtor and a risk averse creditor. The quantitative analysis of the model shows that high creditor income results in both longer delays in renegotiations and smaller haircuts. Our theoretical predictions are supported by data.
    JEL: F34 F41 H63
    Date: 2019–05
  18. By: Beetsma, Roel; Chen, Damiaan; van Wijnbergen, Sweder
    Abstract: Pension schemes generally aim to protect the purchasing power of their participants, but cannot completely do this when due to market incompleteness inflation risk cannot be fully hedged. Without a market price for inflation risk the value of a pension contract depends on the investor's risk appetite and inflation risk exposure. We develop a valuation framework to deal with two sources of unhedgeable inflation risk: the absence of instruments to hedge general consumer price inflation risk and differences in group-specific consumption bundles from the economy-wide bundle. We find that the absence of financial instruments to hedge inflation risks may reduce lifetime welfare by up to 6% of certainty-equivalent consumption for commonly assumed degrees of risk aversion. Regulators face a dilemma as young (workers) and old participants (retirees) have different capacities to absorb losses from unhedgeable inflation risks and as a consequence have a different risk appetite.
    Keywords: incomplete markets; pension contract; Unhedgeable inflation risk; Valuation; welfare loss
    JEL: C61 E21 G11 G23
    Date: 2019–05

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.