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on Utility Models and Prospect Theory |
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Issue of 2019‒10‒14
twenty-one papers chosen by |
| By: | Samuel Shye; Ido Haber |
| Abstract: | Challenge Theory (CT), a new approach to decision under risk departs significantly from expected utility, and is based on firmly psychological, rather than economic, assumptions. The paper demonstrates that a purely cognitive-psychological paradigm for decision under risk can yield excellent predictions, comparable to those attained by more complex economic or psychological models that remain attached to conventional economic constructs and assumptions. The study presents a new model for predicting the popularity of choices made in binary risk problems. A CT-based regression model is tested on data gathered from 126 respondents who indicated their preferences with respect to 44 choice problems. Results support CT's central hypothesis, strongly associating between the Challenge Index (CI) attributable to every binary risk problem, and the observed popularity of the bold prospect in that problem (with r=-0.92 and r=-0.93 for gains and for losses, respectively). The novelty of the CT perspective as a new paradigm is illuminated by its simple, single-index (CI) representation of psychological effects proposed by Prospect Theory for describing choice behavior (certainty effect, reflection effect, overweighting small probabilities and loss aversion). |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1910.04487&r=all |
| By: | Neszveda, G. (Tilburg University, School of Economics and Management) |
| Abstract: | Despite the fact that almost everyone faces risk in their lives and it is a crucial ingredient in economic models including asset pricing models, it is still an open debate how decision-makers or even investors evaluate risk. Experimental and empirical evidence shows that the standard expected utility theory falls short of explaining many economic and asset pricing phenomena. Behavioral finance provides alternative conceptual frameworks to explain these phenomena. This dissertation consists of 3 chapters investigating the impacts of some of the conceptual frameworks in behavioral finance. Chapter 1 investigates the potential impact of the expected utility theory with an aspiration level on stock returns. Chapter 2 investigates the impact of the law of small numbers on stock returns. Chapter 3 investigates the relation between time discounting and risk taking in an experiment. |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:tiu:tiutis:05059039-5236-42a3-be1b-3c1be952551b&r=all |
| By: | Alexander Adamou; Yonatan Berman; Diomides Mavroyiannis; Ole Peters |
| Abstract: | An important question in economics is how people choose between different payments in the future. The classical normative model predicts that a decision maker discounts a later payment relative to an earlier one by an exponential function of the time between them. Descriptive models use non-exponential functions to fit observed behavioral phenomena, such as preference reversal. Here we propose a model of discounting, consistent with standard axioms of choice, in which decision makers maximize the growth rate of their wealth. Four specifications of the model produce four forms of discounting -- no discounting, exponential, hyperbolic, and a hybrid of exponential and hyperbolic -- two of which predict preference reversal. Our model requires no assumption of behavioral bias or payment risk. |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1910.02137&r=all |
| By: | Ibrahim Ekren; Sergey Nadtochiy |
| Abstract: | In this paper, we construct the utility-based optimal hedging strategy for a European-type option in the Almgren-Chriss model with temporary price impact. The main mathematical challenge of this work stems from the degeneracy of the second order terms and the quadratic growth of the first order terms in the associated HJB equation, which makes it difficult to establish sufficient regularity of the value function needed to construct the optimal strategy in a feedback form. By combining the analytic and probabilistic tools for describing the value function and the optimal strategy, we establish the feedback representation of the latter. We use this representation to derive an explicit asymptotic expansion of the utility indifference price of the option, which allows us to quantify the price impact in options' market via the price impact coefficient in the underlying market. Finally, we describe a game between competing market makers for the option and construct an equilibrium in which the option is traded at the utility indifference price. |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1910.01778&r=all |
| By: | Martine Visser; Hafsah Jumare; Kerri Brick |
| Abstract: | We use a series of credit and insurance simulation games to test the role of access to credit and insurance on magnitude and timing of farm technology uptake with small-scale farmers in South Africa. Using Cumulative Prospect Theory, we assess how insurance impacts technology uptake given risk preferences. Our findings suggest that risk aversion is linked to lower uptake of the insured technology. while loss averse farmers are more likely to adopt technology bundled with insurance. Higher weighting of small probability events leads to later uptake of the uninsured technology option. We further find that wealth is critical in uptake of technology, with cumulative experimental income and real household income stifling investment in insured and uninsured technology options even when real wealth is not at stake. Overall, we find that insurance is not sufficient to counter the behavioural factors linked to asset constraints and risk preferences that suppress modern farm technology uptake. |
| Keywords: | Risk Preference, Poverty-Trap, Insurance, Farm, Technology, experiment |
| JEL: | D9 D2 D8 C6 C9 O1 Q1 |
| Date: | 2019–03 |
| URL: | http://d.repec.org/n?u=RePEc:rza:wpaper:776&r=all |
| By: | Randall Martyr; John Moriarty |
| Abstract: | We obtain structural results for non-Markovian optimal stopping problems in discrete time when the decision maker is risk averse and has partial information about the stochastic sequences generating the costs. Time consistency is ensured in the problem by the aggregation of a sequence of conditional risk mappings, and the framework allows for model ambiguity. A reflected backward stochastic difference equation is used to characterise the value function and optimal stopping times. |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1910.04047&r=all |
| By: | Bianchi, Milo; Jehiel, Philippe |
| Abstract: | We study banks incentive to pool assets of heterogeneous quality when investors evaluate pools by extrapolating from limited sampling. Pooling assets of heterogeneous quality induces dispersion in investors valuations without affecting their average. Prices are determined by market clearing assuming that investors cannot borrow nor short-sell. A monopolistic bank has the incentive to create heterogeneous bundles only when investors have enough money. When the number of banks is sufficiently large, oligopolistic banks choose extremely heterogeneous bundles, even when investors have little money and even if this turns out to be collectively detrimental to the banks. If in addition banks can originate low quality assets, even at a cost, this collective inefficiency is exacerbated and pure welfare losses arise. Robustness to the presence of rational investors and to the possibility of short-selling is discussed. |
| Keywords: | complex nancial products; bounded rationality; disagreement; market e¢ ciency; sampling. |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:tse:wpaper:123622&r=all |
| By: | Sylvain Béal (Université de Bourgogne Franche-Comté, CRESE); Issofa Moyouwou (Department of Mathematics, University of Yaounde I - Cameroon); Eric Rémila (Université de Saint-Etienne, CNRS UMR 5824 GATE Lyon Saint-Etienne, France); Philippe Solal (Université de Saint-Etienne, CNRS UMR 5824 GATE Lyon Saint-Etienne, France) |
| Abstract: | A situation in which a finite set of agents can obtain certain payoffs by cooperation can be described by a cooperative game with transferable utility, or simply a TU-game. In the literature, various models of games with restricted cooperation can be found, in which only certain subsets of the agent set are allowed to form. In this article, we consider such sets of feasible coalitions that are closed under intersection, i.e., for any two feasible coalitions, their intersection is also feasible. Such set systems, called intersection closed systems, are a generalization of the convex geometries. We use the concept of closure operator for intersection closed systems and we define the restricted TU-game taking into account the limited possibilities of cooperation determined by the intersection closed system. Next, we study the properties of this restricted TU-game. Finally, we introduce and axiomatically characterize a family of allocation rules for games TU-games on intersection closed systems, which contains a natural extension of the Shapley value. |
| Date: | 2019–06 |
| URL: | http://d.repec.org/n?u=RePEc:crb:wpaper:2019-06&r=all |
| By: | Raphaël Soubeyran (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) |
| Abstract: | In this paper, I study the design of least cost technology adoption subsidy schemes when the individuals' decisions are affected by peer effects and pro-social motivations. I show that pro-social preferences lead to lower individual subsidies whether peer effects are positive or negative. However, the form of the optimal scheme strongly depends on the type of peer effects. When peer effects are positive pro-social preferences lead to an increase in objective inequality -the difference between individual material payoffs- while they lead to a decrease in subjective inequality -the difference between individual utility levels. When peer effects are negative, the optimal subsidy scheme is uniform, that is all the individuals receive the same subsidy. The model delivers insights for the design of a large range of intervention programs supporting the adoption of new technologies, both in contexts where peer effects are positive (as has been shown in the case of malaria prevention technologies and modern agricultural inputs) and in contexts where peer effects are negative (as has been shown in the case of deworming pills). |
| Keywords: | pro-social preferences.,incentives,inequality,externality,principal,agents |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpceem:halshs-02291905&r=all |
| By: | Fuchs-Seliger, Susanne |
| Abstract: | Describing individual behavior, we will be concerned with an axiom system, which can be interpreted by Shephard's distance function. Based on this function, one can discover the individual's preference relation, from which the individual's demand function can be derived. We will realize that the axiom system describes rational behavior, satisfying the Strong Axiom of Revealed Preference. The axiom system presented in this article is closely related to a former one describing consumer behavior by income compensation functions. These different approaches will help to illuminate choice behavior from different points of view. We will also see that the axiom system presented in this article can be interpreted by the economic quantity index in welfare theory and by distance functions in producer theory. |
| Keywords: | Economic Models,Demand Functions,Distance Functions,Rationality,Producer Theory,Welfare Theory |
| JEL: | D71 C78 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:kitwps:136&r=all |
| By: | Carlsson, Fredrik (Department of Economics, School of Business, Economics and Law, Göteborg University); Kataria, Mitesh (Department of Economics, School of Business, Economics and Law, Göteborg University); Lampi, Elina (Department of Economics, School of Business, Economics and Law, Göteborg University); Martinsson, Peter (Department of Economics, School of Business, Economics and Law, Göteborg University) |
| Abstract: | Households’ demand for electricity continues to increase. This trend per se should indicate increased disutility from power outages. On the other hand, batteries and other back-up systems have been improved and the frequency and duration of outages have been reduced in many countries. By comparing the results from two stated preference studies on Swedish households’ willingness to pay to avoid power outages in 2004 and 2017, we investigate whether the willingness to pay has changed. The willingness to pay is assessed for power outages of different durations, and whether it is planned or unplanned. We find three main differences: i) The proportion of households stating zero willingness to pay to avoid power outages decreased significantly from 2004 to 2017 and ii) the overall WTP was considerably higher in 2017 than in 2014, but iii) the WTP for duration of an outage has decreased. These results have implications for how regulators incentivize and regulate electricity suppliers since they suggest that a reliable supply of electricity is of greater importance now than what earlier studies have suggested. |
| Keywords: | Power outage; stated preferences; Sweden |
| JEL: | D12 Q40 Q41 |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:gunwpe:0776&r=all |
| By: | Ahmet Ak; Oner Gumus |
| Abstract: | In economics literature, it is accepted that all people are rational and they try to maximize their utilities as possible as they can. In addition, economic theories are formed with the assumptions not suitable to real life. For instance, indifference curves are drawn with the assumptions that there are two goods, people are rational, more is preferred to less and so on. Hence, the consumer behaviors are guessed according to this analysis. Nevertheless, these are invalid in real life. And this inconsistencey are examined by behavioral economics and neuroeconomics. Behavioral economics claims that people can behave what they are not expected since people can be irrational, their willpower is limited and altruistic behaviors can be seen and they can give more value to what they own. As a result of these, consumer behaviors become more different than that of economic theory. In addition to behavioral economics, neuroeconomics also examines consumer behaviors more differently than mainstream economic theory. It emphasizes the people using prefrontial cortex of the brain are more rational than the people using hippocampus of the brain. Therefore, people can make illogical choices compared to economic theory. In these cases, levying taxes such as personal income tax or value added tax can be ineffective or effective. In other words, the effect becomes ambigious. Hence,the hypothesis that if government desires to levy personal income tax or value added tax, it makes a detailed research in terms of productivity of taxes forms the fundamental of this study. |
| Date: | 2019–09 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1910.03141&r=all |
| By: | Vasilev, Aleksandar |
| Abstract: | This paper takes an otherwise standard real-business-cycle setup with government sector, and augments it with shocks to consumer confidence to study business cycle fluctuations. A surprise increase in consumer confidence generates higher utility, as the household values consumption more in that scenario. As a test case, the model is calibrated to Bulgaria after the introduction of the currency board (1999-2018). We find that shocks to consumer confidence by themselves cannot be the main driving force behind business cycle fluctuations, but when combined with technology shocks, model performance improves substantially. Therefore, allowing for additional factors, such as consumer confidence, to interact with technology shocks can be useful in explaining business cycle movements. |
| Keywords: | consumer confidence shocks,business cycles,Bulgaria |
| JEL: | E32 E62 E21 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:leafwp:1903&r=all |
| By: | Ciani, Emanuele; Delavande, Adeline; Etheridge, Ben; Francesconi, Marco |
| Abstract: | Subjective expectations about future policy play an important role in individuals' welfare. We examine how workers' expectations about pension reform vary with proximity to reforms, information cost, and aggregate information acquisition. We construct a new pan-European dataset of reform implementations and government announcements, and combine it with individual-level representative survey data on expectations about future reforms and country-level data on online search. We ï¬ nd: (1) Expectations are revised upward by about 10 percentage points in the year leading up to a reform, from a median of 50%, regardless of whether the reform is announced; (2) Aggregate online search increases after announcements, when the cost of information is lower; (3) Reform announcements and online information gathering are substitutes in the formation of expectations; (4) Expectations do not converge as a result of announcements or implementations; (5) The eï¬?ect of information on expectations varies substantially across workers and systematically with observed characteristics that proxy cognitive ability and information value. These ï¬ ndings, interpreted using a model of rational inattention, reveal substantial informational rigidities, with welfare costs that run into trillions of Euros. |
| Keywords: | Expectations; online search; Pension reform uncertainty; rational inattention; Reform announcement; retirement |
| JEL: | C8 D84 D91 J14 |
| Date: | 2019–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:13988&r=all |
| By: | Stark, Oded; Byra, Lukasz |
| Abstract: | Drawing on a model in which utility is derived from consumption and effort (labor supply), we ask how the deportation of a number of undocumented migrants influences the decisions regarding labor supply, consumption, and savings of the remaining undocumented migrants. We assume that the intensity of deportation serves as an indicator to the remaining undocumented migrants when they assess the probability of being deported. We find that a higher rate of deportation induces undocumented migrants to work harder, consume less and, as a result of those responses, to save more. Assuming that the purpose of deportation policy is to reduce the aggregate labor supply of undocumented migrants in order to raise the wages of low-skilled native workers, we conclude that the policy can backfire: an increase in the labor supply of the remaining undocumented migrants can more than offset the reduction in the labor supply arising from the deportation of some undocumented migrants. Simulation shows that if the number of deportations in relation to the size of the undocumented migrant workforce is small, then the combined effect of the reduction in the labor supply of the deportees and the increase in the labor supply of the remaining undocumented migrants can be that the aggregate labor supply of undocumented migrants will increase. It follows that an effective deportation policy has to involve the expulsion of a substantial proportion of the total number of undocumented migrants in the workforce. |
| Keywords: | Consumer/Household Economics, Labor and Human Capital, Risk and Uncertainty |
| Date: | 2019–10–08 |
| URL: | http://d.repec.org/n?u=RePEc:ags:ubzefd:293929&r=all |
| By: | Lionel de Boisdeffre (Université Paris 1 - Centre d'Economie de la Sorbonne) |
| Abstract: | The paper demonstrates the generic existence of general equilibria in incomplete markets with well behaved price properties. The economy has two periods and an ex ante uncertainty over the state of nature to be revealed at the second period. Securities pay off in cash or commodities at the second period, conditionally on the state of nature to be revealed. They permit financial transfers across periods and states, which are insufficient to span all state contingent claims to value, whatever the spot price to prevail. Under smooth preference and the standard Radner (1972) perfect foresight assumptions, equilibrium is shown to exist, except for a closed set of measure zero of endowments and securities. The proof provides additional arguments and insights to Duffie-Shafer's (1985) on the same subject and refines it in two ways. First, equilibrium in shown to exist generically for any norm values of commodity prices on any spot market, and for any collection of state prices. Second, assets need no longer pay off in commodities, but may in any mix of cash and goods |
| Keywords: | sequential equilibrium; temporary equilibrium; perfect foresight; existence; rational expectations; financial markets; asymmetric information; arbitrage |
| JEL: | D52 |
| Date: | 2019–06 |
| URL: | http://d.repec.org/n?u=RePEc:mse:cesdoc:19011&r=all |
| By: | Soumyatanu Mukherjee; Sidhartha S Padhi |
| Abstract: | This paper studies the decision problem of risk averse single-output producers and suppliers under uncertainties in input prices, in a two-moment decision model with the presence of a dependent background risk. This framework is based on the utility from the expected value and the standard deviation of the uncertain random total profit of the supplier. Our theoritical framework for studying producers' responses to risks allows not only for analysing risk averse suppliers' attitude towards endogenous and background risks, but also to identify how the changes in the connectivity (ie correlation) between these two broad sources of risks will affect the risk averse suppliers' decision at the optimum. All comparative static effects are described in terms of the relative sensitivity of the supplier towards risks. This analytical framework has a number of potential application in development economics, such as optimal production decision under energy price uncertainty, ouput price uncertainty, and exchange rate uncertainty. |
| Keywords: | supply chain management, risk management, two-moment decision model, background risk |
| Date: | 2018 |
| URL: | http://d.repec.org/n?u=RePEc:not:notcre:18/11&r=all |
| By: | Francesco Cerigioni; Fabrizio Germano; Pedro Rey-Biel; Peio Zuazo-Garin |
| Abstract: | Identifying individual levels of rationality is crucial to modeling strategic interaction and understanding behavior in games. Nevertheless, there is no consensus on how to best identify levels of higher order rationality, and the identification of an empirical distribution remains highly elusive. In particular, the games used for the task can have a huge impact on the identified distribution. To tackle this fundamental problem, this paper introduces an axiomatic approach that singles out a simple class of games that minimizes the probability of misidentification errors. It then shows that the axioms are empirically meaningful in a within subject experiment that compares the distribution of orders of rationality across different games, including standard games from the literature. The games singled out by the axioms exhibit the highest correlation both with the distribution of the most frequent rationality level a subject has been classified with and with an independent measure of cognitive ability. Finally, there is no evidence in our sample of within subject consistency of identified rationality levels across games. |
| Keywords: | rationality, higher-order rationality, revealed rationality, levels of thinking |
| JEL: | C70 C72 C91 D01 D80 |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:bge:wpaper:1120&r=all |
| By: | Roman Horvath (Charles University in Prague); Lóránt Kaszab (Magyar Nemzeti Bank (Central Bank of Hungary)); Ales Marsal (National Bank of Slovakia) |
| Abstract: | We estimate a New Keynesian model on post-war US data with generalised method of moments using either constant or time-varying debt and labor income taxes. We show that accounting for government debt and distortionary taxes help the New Keynesian model match the level of the nominal term premium with a lower relative risk-aversion than typically found in the literature. |
| Keywords: | zero-coupon bond, nominal term premium, balanced budget rule, government debt, income taxation |
| JEL: | E13 E31 E43 E44 E62 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:mnb:wpaper:2019/2&r=all |
| By: | Andres Hincapie (University of North Carolina at Chapel H) |
| Abstract: | Most individuals do not start a business and, if they do, they start well into their thirties. I study multiple mechanisms explaining these stylized facts. Using the Panel Study of Income Dynamics, I estimate a dynamic Roy model with accumulation of experience, risk aversion, and imperfect information about ability. Risk aversion reduces entrepreneurship by up to 40% and providing full information about ability increases it by 35%. The gap in first entry ages between paid employment and entrepreneurship results mainly from entry costs and information frictions. I study counterfactual policies (subsidies and education) that target these barriers to young entrepreneurship, thereby closing the gap, and show that fostering young entrepreneurship can yield higher returns than fostering entrepreneurship later in individuals' careers because the gains from early information are larger. |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed019:735&r=all |
| By: | Yifan Gong; Lance Lochner; Ralph Stinebrickner; Todd R. Stinebrickner |
| Abstract: | This paper uses the Euler equation and novel data from Berea College students on their consumption expenditures during and after college, desired borrowing amounts, beliefs about post-college earnings, and elicited risk-aversion and time preference parameters to determine their consumption value of college attendance. Estimates suggest an average annual consumption value of college as high as $11,600, with considerable heterogeneity across students. Incorporating these benefits raises the average expected return to college by as much as 14%. |
| JEL: | I20 I21 I23 I28 |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:26335&r=all |