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on Utility Models and Prospect Theory |
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Issue of 2019‒10‒28
thirteen papers chosen by |
| By: | Daniel Muller; Tshilidzi Marwala |
| Abstract: | The famous St Petersburg Paradox shows that the theory of expected value does not capture the real-world economics of decision-making problem. Over the years, many economic theories were developed to resolve the paradox and explain the subjective utility of the expected outcomes and risk aversion. In this paper, we use the concept of the net utility to resolve the St Petersburg paradox. The reason why the principle of absolute instead of net utility does not work is because it is a first order approximation of some unknown utility function. Because the net utility concept is able to explain both behavioral economics and the St Petersburg paradox it is deemed a universal approach to handling utility. Finally, this paper explored how artificial intelligent (AI) agent will make choices and observed that if AI agent uses the nominal utility approach it will see infinite reward while if it uses the net utility approach it will see the limited reward that human beings see. |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1910.09544&r=all |
| By: | Rablen, Matthew D. (University of Sheffield) |
| Abstract: | The psychological basis for rank-dependent probability weighting, and for an inverse-S probability weighting function (PWF) in particular, has often been questioned. I examine the existence and shape of the PWF in a model allowing for optimism/pessimism over probability distributions and for loss averse/gain loving stochastic reference dependence. I give commonly observed shapes of PWF a psychological interpretation. In particular, I establish a deep connection between two of the most established phenomena in decisionmaking: loss aversion and the inverse-S PWF: the former is a pre- condition for the latter. |
| Keywords: | probability weighting, rank dependent expected utility, loss aversion, reference dependence, optimism, pessimism |
| JEL: | D81 D01 |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp12701&r=all |
| By: | Stanislaw Maciej Kot (Gdansk University of Technology, Gdansk, Poland) |
| Abstract: | In this paper, the method of deriving the parameter ? of inequality aversion from a parametric distribution of incomes is proposed. It is assumed that a social decision-maker appraises welfare in income distributions by means of the constant inequality aversion utility function and that incomes obey the generalised beta distribution of the second kind GB2(a,b,p,q). It is proved that, under these assumptions, the social welfare function exists if and only if ? belongs to [0,ap+1) interval. The mid-point ?mid of this interval specifies inequality aversion of the median social-decision maker. The maximum likelihood estimator of ?mid has been developed. Inequality aversion for Poland 1998-2015 has been estimated. If inequality is calculated on the basis of disposable incomes, the standard inequality-development relationship might be complemented by inequality aversion. Such an augmented inequality-development relationship discloses new evidences. For instance, the Gini index is not a declining function of ? in general, but only for a high stage of the economic development. |
| Keywords: | Inequality; Inequality aversion; Income distribution; Utility function |
| JEL: | D30 O15 |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:gdk:wpaper:58&r=all |
| By: | Bnaya Dreyfuss; Ori Heffetz; Matthew Rabin |
| Abstract: | Deferred Acceptance (DA), a widely implemented algorithm, is meant to improve allocations: under classical preferences, it induces preference-concordant rankings. However, recent evidence shows that—in both real, large-stakes applications and experiments—participants frequently play seemingly dominated, significantly costly, strategies that avoid small chances of good outcomes. We show theoretically why, with expectations-based loss aversion, this behavior may be partly intentional. Reanalyzing existing experimental data on random serial dictatorship (a restriction of DA), we show that such reference-dependent preferences, with a degree and distribution of loss aversion that explain common levels of risk aversion elsewhere, fit the data better than no-loss-aversion preferences. |
| JEL: | B49 D47 D82 D84 D91 |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:26394&r=all |
| By: | Chang, Kuo-Ping |
| Abstract: | Behavioral economics, notably developed by Daniel Kahneman, Amos Tversky and Richard Thaler, has found consistent and pervasive anomalies in common people’s daily behaviors. This paper has employed the concepts in traditional economics (e.g., choice, relative price, and opportunity cost) to analyze the anomalies found in behavioral economics. The results show that quite a few anomalies, such as preference reversal, isolation effect and sunk cost fallacy, do not exist. This is not to say that people always make rational choices. The findings of the paper conclude, however, that common people may not be as irrational as behavioral economists have suggested (in some situations, common people may act more like a rational economist). |
| Keywords: | Choice, sunk cost fallacy, relative price ratio (rate of return), prospect theory, endowment effect. |
| JEL: | D11 D9 |
| Date: | 2019–01–25 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:96561&r=all |
| By: | Yanfei Bai; Zhongbao Zhou; Helu Xiao; Rui Gao; Feimin Zhong |
| Abstract: | This paper investigates a hybrid stochastic differential reinsurance and investment game between one reinsurer and two insurers, including a stochastic Stackelberg differential subgame and a non-zero-sum stochastic differential subgame. The reinsurer, as the leader of the Stackelberg game, can price reinsurance premium and invest its wealth in a financial market that contains a risk-free asset and a risky asset. The two insurers, as the followers of the Stackelberg game, can purchase proportional reinsurance from the reinsurer and invest in the same financial market. The competitive relationship between two insurers is modeled by the non-zero-sum game, and their decision making will consider the relative performance measured by the difference in their terminal wealth. We consider wealth processes with delay to characterize the bounded memory feature. This paper aims to find the equilibrium strategy for the reinsurer and insurers by maximizing the expected utility of the reinsurer's terminal wealth with delay and maximizing the expected utility of the combination of insurers' terminal wealth and the relative performance with delay. By using the idea of backward induction and the dynamic programming approach, we derive the equilibrium strategy and value functions explicitly. Then, we provide the corresponding verification theorem. Finally, some numerical examples and sensitivity analysis are presented to demonstrate the effects of model parameters on the equilibrium strategy. We find the delay factor discourages or stimulates investment depending on the length of delay. Moreover, competitive factors between two insurers make their optimal reinsurance-investment strategy interact, and reduce reinsurance demand and reinsurance premium price. |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1910.09834&r=all |
| By: | Philippe Choné (CREST - Centre de Recherche en Économie et Statistique - ENSAI - Ecole Nationale de la Statistique et de l'Analyse de l'Information [Bruz] - X - École polytechnique - ENSAE ParisTech - École Nationale de la Statistique et de l'Administration Économique - CNRS - Centre National de la Recherche Scientifique); Laurent Linnemer (CREST - Centre de Recherche en Économie et Statistique - ENSAI - Ecole Nationale de la Statistique et de l'Analyse de l'Information [Bruz] - X - École polytechnique - ENSAE ParisTech - École Nationale de la Statistique et de l'Administration Économique - CNRS - Centre National de la Recherche Scientifique) |
| Abstract: | The quasi-linear quadratic utility model is widely used in economics. The knowledge of its exact origin is less widespread. A first contribution of the paper is to explain the genesis of this model. Next, we review the main properties of the general model, mainly following the previous literature. Finally, it is shown that all the tractable versions of the model used in practice are (almost) identical and have a mean variance structure. We provide ready-to-use formulae for this symmetric model. |
| Date: | 2019–10–17 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-02318633&r=all |
| By: | Oechssler, Jörg; Roomets, Alex |
| Abstract: | The Savage and the Anscombe-Aumann frameworks are the two most popular approaches used when modeling ambiguity. The former is more flexible, but the latter is often preferred for its simplicity. We conduct an experiment where subjects place bets on the joint outcome of an ambiguous urn and a fair coin. We document that more than a third of our subjects make choices that are incompatible with Anscombe-Aumann for any preferences, while the Savage framework is flexible enough to accountfor subjects' behaviors. |
| Keywords: | Ellsberg paradox; ambiguity; experiment |
| Date: | 2019–10–18 |
| URL: | http://d.repec.org/n?u=RePEc:awi:wpaper:0672&r=all |
| By: | Aïleen Lotz (Cerca Trova) |
| Abstract: | This paper extends the notion of the rational agent in economics by acknowledging the role of the unconscious in the agent's decision-making process. It argues that the unconscious can be modelled by a rational agent with his own objective function and set of information. The combination of both the conscious and unconscious agents is called the dual agent. This dual agent presents rationally biased behaviors that may persist through aggregation and could be potentially measured. It also provides a theoretical approach to the emotionally-driven actions. |
| Keywords: | dual agent,conscious and unconscious,rationality,multi-rationality,emotions,choices and preferences,multi-agent model,consistency |
| Date: | 2019–10–13 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-02314663&r=all |
| By: | Yuta Inoue (Graduate School of Economics, Waseda University); Koji Shirai (School of Economics, Kwansei Gakuin University) |
| Abstract: | This paper develops revealed preference tests for choice models under limited consideration, allowing a partially observed data set. Leading theories in the literature such as the limited attention model, the rationalization model, the categorize-then-choose model, and the rational shortlisting models are covered. Given a tool for testing limited consideration models, we analyze the empirical aspects of them. Our revealed preference tests are applied to randomly generated data sets to compare the strength of observable restrictions across various models. In addition, we carried out an experiment to compare models in terms of Selten’s index, which is a measure for plausibility of a model in explaining a given data set. As a result, remarkable differences are seen both in observable restrictions and Selten’s indices across models. |
| Keywords: | Revealed preference; Limited consideration; Limited attention; Rational shortlisting; Bronars’ test; Selten’s index |
| JEL: | C6 D1 D8 |
| Date: | 2018–03 |
| URL: | http://d.repec.org/n?u=RePEc:kgu:wpaper:176-2&r=all |
| By: | Kouadio, Jean Joel; Mwamba, Muteba; Bonga-Bonga, Lumengo |
| Abstract: | This paper assesses the impact of systematic tail risk of stocks, defined as a stock’s exposure to market tail events, on the cross section returns of an emerging stock exchange, especially the Johannesburg Stock Exchange (JSE) from January 2002 through June 2018. If stock market investors are crash-averse, then holding stocks that experience high exposure to market tail events should be rewarded with a premium. The paper therefore sets out to determine whether high exposure to market tail events translates into higher returns of stocks traded on the JSE. To achieve this objective, the study extends on the work of Chabi-Yo, Ruenzi and Weigert (2015) based on extreme value theory (EVT) and copula models as well as the traditional asset pricing tools of portfolio formation and cross-sectional regressions. The results of the empirical analysis support the existence of a systematic tail risk premium in the JSE. Interestingly, the effect of systematic tail risk on the cross section of JSE returns is time-varying and independent from that of risk measures such as beta and downside beta and firm characteristics such as book-to-market (BTM) ratio, size and past returns. In addition, the study provides evidence on the impact of financial crises on crash aversion. |
| Keywords: | systematic tail risk, stock exchange, extreme value theory, copula |
| JEL: | C46 G01 G12 |
| Date: | 2019–10–12 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:96570&r=all |
| By: | M. E. Bontempi; M. Frigeri; R. Golinelli; M. Squadrani |
| Abstract: | Macroeconomic uncertainty consists of three components: the unobservable, the heterogeneous and the “uncertain”. We are unaware of exactly when economic agents perceive uncertainty and which type of uncertainty interests them. This paper introduces and outlines a way of conducting large-scale data searches on the Web. We create the EURQ index of “economic uncertainty related queries” for both the USA and Italy. We show that the EURQ encapsulates agents’ need to gather more information during periods of uncertainty. This need either spontaneously arises in the case of macro-real and political uncertainty, or is induced by the media in the case of normative and financial uncertainty. This distinction is extremely important when trying to understand the immediate impact of fiscal policy uncertainty on economic variables, and how financial shocks can produce a significant short-term impact on economic activity. It is also helpful when trying to solve the identification and endogeneity issues encountered in the literature when assessing the role of uncertainty. |
| JEL: | D80 D91 E66 C32 H30 |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:bol:bodewp:wp1134&r=all |
| By: | Jan Priebe (German Institute of Global and Area Studies (GIGA), Hamburg, Germany); Ute Rink (University of Goettingen); Henry Stemmler (University of Goettingen) |
| Abstract: | This paper looks at individual risk behavior and disability in Vietnam, where many households live with a disabled family member. Due to the Vietnam war, disability is a common phenomenon and shapes individuals’ daily life and decision making. Using longitudinal data of 2200 households in Vietnam and an instrumental variable strategy, we show that individuals who live with a disabled family member are more risk averse than others. In addition we employ field experiments and psychological primes to elicit risk and loss behavior of individuals living in the Vietnam province Ha-Thinh. The experimental results, underpin our panel results. We show in addition that a negative recollection of health issues, leads to a lower risk attitude of individuals who do not live with a disabled family member and that individuals who live with a disabled family member are less loss averse. Our findings are causal and contribute to existing studies showing that households who are characterized by higher backward risks are more risk averse than others. |
| Keywords: | risk, disability, Vietnam |
| JEL: | I14 D1 Z1 |
| URL: | http://d.repec.org/n?u=RePEc:got:gotcrc:267&r=all |