nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2019‒11‒25
seventeen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Relative deprivation as a cause of risky behaviors By Stark, Oded
  2. Pure rank preferences and variation in risk-taking behavior By Stark, Oded; Budzinski, Wiktor; Jakubek, Marcin
  3. Probability Weighting and Cognitive Ability By Syngjoo Choi; Jeongbin Kim; Eungik Lee; Jungmin Lee
  4. The Delimitation of Giffenity for The Wold-Juréen (1953) Utility Function Using Relative Prices: A Note By Sproule, Robert
  5. Somewhere Between Utopia and Dystopia: Choosing From Multiple Incomparable Prospects By Gordon Anderson; Thierry Post; YOON-JAE WHANG
  6. A Generalized Markov Chain Model to Capture Dynamic Preferences and Choice Overload By Kumar Goutam; Vineet Goyal; Agathe Soret
  7. Costly Information Acquisition By Liu, Ce; Chambers, Christopher; Rehbeck, John
  8. How Do Couples Choose Individual Insurance Plans? Evidence from Medicare Part D By Tomas Pedro Sanguinetti
  9. "On the Stability of Preferences:Experimental Evidence from Two Disasters" By Yusuke Kuroishi; Yasuyuki Sawada
  10. Tractable Rare Disaster Probability and Options-Pricing By Robert J. Barro; Gordon Y. Liao
  11. Limited Impact of Business Development Programs on Entrepreneurs¡¯ Pro?tability in the Presence of Ambiguity Aversion By Dmitry Shapiro
  12. Transitivity of preferences: When does it matter? By Laurens Cherchye; Thomas Demuynck; Bram De Rock
  13. Belief Formation Under Signal Correlation By Tanjim Hossain; Ryo Okui
  14. "Interest rate model with fundamental uncertaintiesTaiga Saito, Akihiko Takahashi" By Taiga Saito; Akihiko Takahashi
  15. Understanding Alcohol Consumption across Countries By Kenneth W. Clements; Yihui Lan; Haiyan Liu
  16. Assortative matching with network spillovers By Bjerre-Nielsen, Andreas
  17. Time Discounting and Wealth Inequality By Epper, Thomas; Fehr, Ernst; Fehr-Duda, Helga; Thustrup Kreiner, Claus; Dreyer Lassen, David; Leth-Petersen, Søren; Nytoft Rasmussen, Gregers

  1. By: Stark, Oded
    Abstract: Combining a standard measure of concern about low relative wealth and a standard measure of relative risk aversion leads to a novel explanation of variation in risk-taking behavior identified and documented by social psychologists and economists. We obtain two results: (1) Holding individual i’s wealth and his rank in the wealth distribution constant, the individual’s relative risk aversion decreases when he becomes more relatively deprived as a result of an increase in the average wealth of the individuals who are wealthier than he is. (2) If relative deprivation enters the individual’s utility function approximately linearly then, holding constant individual i’s wealth and the average wealth of the individuals who are wealthier than he is, the individual’s relative risk aversion decreases when he becomes more relatively deprived as a result of a decline in his rank. Our findings provide a theoretical support for evidence about the propensity of relatively deprived individuals to gamble and resort to other risky behaviors.
    Keywords: Health Economics and Policy, Risk and Uncertainty
    Date: 2019–11–21
  2. By: Stark, Oded; Budzinski, Wiktor; Jakubek, Marcin
    Abstract: Assuming that an individual's rank in the wealth distribution is the only factor determining the individual's wellbeing, we analyze the individual's risk preferences in relation to gaining or losing rank, rather than the individual's risk preferences towards gaining or losing absolute wealth. We show that in this characterization of preferences, a high-ranked individual is more willing than a low-ranked individual to take risks that can provide him with a rise in rank: relative risk aversion with respect to rank in the wealth distribution is a decreasing function of rank. This result is robust to incorporating (the level of) absolute wealth in the individual's utility function.
    Keywords: Financial Economics, Risk and Uncertainty
    Date: 2019–11–21
  3. By: Syngjoo Choi; Jeongbin Kim; Eungik Lee; Jungmin Lee
    Abstract: Probability weighting is a major concept for accommodating systemic departures from expected utility theory. We examine the relation between probability weighting and cognitive ability by conducting laboratory experiments with a pool of subjects with unusually large variation in cognitive ability; native-born South Koreans and North Korean refugees. We find that cognitive ability is related to two distinct features of probability weighting-likelihood insensitivity and optimism. Particularly, the negative association between likelihood insensitivity and cognitive ability is robust to potential confounders and stronger among lower cognitive-ability subjects. Our findings shed light on the sources of anomalous choices against expected utility theory.
    Keywords: probability weighting; cognitive ability; likelihood insensitivity; North Korean refugees
    JEL: C91 D01 D81 D91
    Date: 2018–05
  4. By: Sproule, Robert
    Abstract: In the study of Giffen behavior or “Giffenity”, there remains a paradox. On one hand, the Wold-Juréen (1953) utility function has been touted as the progenitor of a multi-decade search for those two-good, particular utility functions, which exhibit Giffenity. On the other hand, there is no evidence that the Wold-Juréen (1953) utility function has ever been fully evaluated for Giffenity, with perhaps one minor exception, Weber (1997). But there, Weber (1997) showed that the Giffenity of Good 1 depends upon the relative magnitude of income vis-à-vis the price of Good 2. Weber’s precondition is so vague that it lacks broad appeal. This paper offers a new and a clear cut precondition for Giffen behavior under the Wold-Juréen (1953) utility function. That is, we show that if the price of Good 1 is greater than or equal to the price of Good 2, then Good 1 is a Giffen good.
    Keywords: Slutsky decomposition, Giffen paradox, Wold-Juréen (1953) utility function
    JEL: A22 A23 D11
    Date: 2019–10–30
  5. By: Gordon Anderson; Thierry Post; YOON-JAE WHANG
    Abstract: In many fields of decision making, choices have to be made from multiple alternatives, but stochastic dominance rules do not yield a complete ordering due to incomparability of some or all of the prospects. For ranking incomparable prospects, a ¡®UtopiaIndex¡¯ measuring the proximity to a lower envelope of integrated distribution functions is proposed. Economic interpretations in terms of Expected Utility are provided for the envelope and deviations from it. The analysis generalizes the existing Almost Stochastic Dominance concept from pairwise comparison to a joint analysis of an arbitrary number of prospects. The limit distribution fortheempiricalcounterpart of the index for a general class of dynamic processes is derived together with a con- sistent and feasible inference procedure based on subsampling techniques. Empirical applications to Chinese household income data and historical investment returns data show that, in every choice set, a single prospect is ranked above all alternatives at conventional significance levels, despite the incomparability problem.
    Keywords: Almost Stochastic Dominance; Convex Stochastic Dominance; Subsampling; Wellbeing Analysis; Portfolio Choice
    Date: 2018–08
  6. By: Kumar Goutam; Vineet Goyal; Agathe Soret
    Abstract: Assortment optimization is an important problem that arises in many practical applications such as retailing and online advertising where the goal is to find a subset of products from a universe of substitutable products that maximize a seller's expected revenue. The demand and the revenue depend on the substitution behavior of the customers that is captured by a choice model. One of the key challenges is to find the right model for the customer substitution behavior. Many parametric random utility based models have been considered in the literature to capture substitution. However, in all these models, the probability of purchase increases as we add more options to the assortment. This is not true in general and in many settings, the probability of purchase may decrease if we add more products to the assortment, referred to as the {\em choice overload}. In this paper we attempt to address these serious limitations and propose a generalization of the Markov chain based choice model considered in Blanchet et al. In particular, we handle dynamic preferences and the choice overload phenomenon using a {\em Markovian comparison} model that is a generalization of the Markovian substitution framework of Blanchet et al. The Markovian comparison framework allows us to implicitly model the search cost in the choice process and thereby, modeling both dynamic preferences as well as the choice overload phenomenon. We consider the assortment optimization problem for the special case of our generalized Markov chain model where the underlying Markov chain is rank-1 (this is a generalization of the Multinomial Logit model). We show that the assortment optimization problem under this model is NP-hard and present a fully polynomial-time approximation scheme (FPTAS) for this problem.
    Date: 2019–11
  7. By: Liu, Ce (Michigan State University, Department of Economics); Chambers, Christopher (Georgetown University); Rehbeck, John (Ohio State University)
    Abstract: We provide revealed preference characterizations for choices made under various forms of costly information acquisition. We examine nonseparable, multiplicative, and constrained costly information acquisition. In particular, this allows the possibility of unknown time delay for acquiring information. The techniques we use parallel the duality properties in the standard consumer problem.
    Keywords: costly information acquisition; rational inattention
    JEL: C00 C90 D81 D91
    Date: 2019–05–15
  8. By: Tomas Pedro Sanguinetti
    Abstract: This research is the first economic study to investigate how couples make enrollment choices in individual insurance markets. I leverage administrative records for Medicare Part D enrollees to distinguish widows and divorcees from married couples. I estimate a stochastic choice model of household demand that takes into account risk aversion, expenditure risk, risk sharing and inertia. I use the model estimates to study how coordination within couples and interaction between couples and singles affects the way that markets adjust to policies designed to nudge individuals toward choosing higher value plans, particularly with respect to adverse selection. The data reveals striking facts about insurance choice. Strikingly, I find that 78% of couples decide to âpoolâ by buying the same plan. This figure remains constant even for couples with extremely different health risk. My estimates imply that monetary value of plan pooling to the average couple is approximately half their monetary value of inertia, $1,584 vs $3,152. I use the model estimates to conduct several counterfactual policy experiments and find that nudging consumers to choose the plans that maximize their expected utility in a hypothetical deregulated environment without risk adjustment and premium subsidies would increase couplesâ welfare by 11% and decrease singlesâ welfare by 2% on average. Adding the federal governmentâs current risk adjustment formula increases the disparity between welfare gains for couples and welfare losses for singles. Additionally adding the federal governmentâs current formula for subsidizing plan premiums causes the policy to generate average welfare gains among both couples and singles of 36% and 5% respectively.
    JEL: I13 D81
    Date: 2019–11–11
  9. By: Yusuke Kuroishi (London School of Economics); Yasuyuki Sawada (Faculty of Economics, The University of Tokyo and AsianDevelopment Bank)
    Abstract: The literature concerning how preferences are affected by extreme events is char-acterized by mixed findings. To bridge this gap, we investigate the impacts of twodisasters triggered by different natural hazards on present bias, exponential time dis-counting, and curvature parameters of a utility function. These are elicited in anintegrated manner by the convex time budget (CTB) experiments as well as the multi-ple price list (MPL) experiments. Based on these approaches, we employ sui generisexperimental data and accurate disaster damage information from the official metricalsurveys in Iwanuma city of Japan and from satellite images of the East Laguna Villageof the Philippines, which were hit, respectively, by a strong earthquake and tsunami in2011 and serious floods in 2012. First, we find that disaster exposure makes individ-uals more present-biased and less risk-averse regardless of distinctive differences insocio-economic conditions and disaster types. Second, the impact lasted for 6 yearsin both areas, suggesting persistency of the effect. Third, our results are consistentwith emotional channels but not necessarily with a potential market friction in theform of binding liquidity constraints. Our findings suggest that the existing mixedempirical evidence can be attributed to the lack of an integrated and consistent frame-work as well as accurate data on disaster damages, rather than variations in literacyor education levels of experimental subjects.
    Date: 2019–11
  10. By: Robert J. Barro; Gordon Y. Liao
    Abstract: We derive an option-pricing formula from recursive preference and estimate rare disaster probability. The new options-pricing formula applies to far-out-of-the money put options on the stock market when disaster risk dominates, the size distribution of disasters follows a power law, and the economy has a representative agent with Epstein-Zin utility. The formula conforms with options data on the S&P 500 index from 1983-2018 and for analogous indices for other countries. The disaster probability, inferred from monthly fixed effects, is highly correlated across countries, peaks during the 2008-2009 financial crisis, and forecasts equity index returns and growth vulnerabilities in the economy.
    Keywords: Disaster Probability ; Option Prices ; Rare Disaster ; Tail Risk ; Uncertainty ; Volatility
    JEL: E44 G13 G12
    Date: 2019–09–27
  11. By: Dmitry Shapiro
    Abstract: This paper develops a theoretical framework to explain a limited e?ect of business development programs (BDPs) on entrepreneurs¡¯ profit. We argue BDPs limited effect is due to mismatch between a BDPs¡¯ narrow focus on business-promoting strategies and a wider context in which microentrepreneurs operate. Entrepreneurs are ambiguity-averse and have multiple sources of income, e.g. business and wage incomes, that are correlated with each other. We show that for a sufficiently ambiguity-averse entrepreneur with multiple income sources e?cient training can result in pro?t decline. We, further, show that both the ambiguity aversion and the multiplicity of income sources are crucial for our results. Only when the wider context (multiple income sources, ambiguity-aversion) is considered, the business-training impact is limited and can result in post-training profit decline. The limited impact is caused by the diversifying role that the business income plays in households¡¯ finances.
    Keywords: Business development programs; ambiguity aversion; microentrepreneurship
    JEL: O12 O16 D1
    Date: 2019–02
  12. By: Laurens Cherchye; Thomas Demuynck; Bram De Rock
    Abstract: We define necessary and sufficient conditions on prices and incomes under which quantity choices can violate SARP (strong axiom of revealed preference) but not WARP (weak axiom of revealed preference). As SARP extends WARP by additionally imposing transitivity on the revealed preference relation, this effectively defines the conditions under which transitivity adds bite to the empirical analysis. For finite data sets, our characterization takes the form of a triangular condition that must hold for all three-element subsets of normalized prices, and which is easy to verify in practice. For infinite data sets, we formally establish an intuitive connection between our characterization and the concept of Hicksian aggregation. We demonstrate the practical use of our conditions through two empirical illustrations.
    Keywords: C14; D01; D11; D12; Hicksian aggregation; Revealed preferences; SARP; testable implications; transitive preferences; WARP
    Date: 2018–09–01
  13. By: Tanjim Hossain; Ryo Okui
    Abstract: Using a set of incentivized laboratory experiments, we characterize how people form beliefs about a random variable based on independent and correlated signals. First, we theoretically show that, while pure correlation neglect always leads to overvaluing of correlated signals, that may not happen if people also exhibit overprecision perceiving signals to be more precise than they actually are. Our experimental results reveal that, while subjects do overvalue moderately or strongly correlated signals, they undervalue weakly correlated signals, suggesting concurrent presence of correlation neglect and overprecision. Estimated parameters of our model suggest that subjects show a nearly complete level of correlation neglect and also suffer from a high level of overprecision. Additionally, we find that subjects do not fully benefit from wisdom of the crowd-they undervalue aggregated information about others¡¯ actions in favor of their private information. This is consistent with models of overprecision where people do not properly incorporate the variance reducing power of averages.
    Keywords: Correlated and independent signals; information processing; bounded rationality; correlation neglect; overprecision; belief elicitation; wisdom of the crowd
    JEL: C91 D81 D83 D84
    Date: 2019–03
  14. By: Taiga Saito (Faculty of Economics, The University of Tokyo); Akihiko Takahashi (Faculty of Economics, The University of Tokyo)
    Abstract: This paper presents a foundation and concrete examples of yield curve models incorporating fundamental uncertainties, that is, uncertainties about Brownian motions representing fundamental market risks. Firstly, to model aggressive (positive)/conservative (cautious) attitudes towards such fundamental uncertainties, we consider a sup-inf/inf-sup problem on the utility of a representative agent with respect to uncertainties over Brownian motions, i.e. fundamental market risks. Secondly, we show that the problem is solved via a backward-stochastic differential equations (BSDEs) approach. Then, under a probability measure determined by solving the sup-inf/inf-sup problem, we propose interest rate models with those uncertainties and explicitly obtain their term structures of interest rates. Particu- larly, we present two approaches to solving the relevant coupled forward-backward stochastic differential equations (FBSDEs) to obtain expressions of the equilibrium interest rate and the term structure of interest rates. In detail, the first approach is by comparison theorems, and the second approach is to predetermine the signs of the volatilities of the BSDE in the coupled system and confirm them by explicitly solving the separated BSDE. Finally, we present concrete examples with numerical experiments.
    Date: 2019–11
  15. By: Kenneth W. Clements (Business School, The University of Western Australia); Yihui Lan (Business School, The University of Western Australia); Haiyan Liu (Business School, The University of Western Australia)
    Abstract: With unpublished data from the International Comparison Program that cover the consumption of three alcoholic beverages in over 150 countries, we analyse drinking patterns around the world with an index-number approach, by estimating a demand system, and by studying the interaction among beverages in generating utility. We consider a separate demand system for each income quartile and find that tastes are not too different acorss quartiles. Broadly speaking, the results are robust to rolling sub-samples of countries, an alternative demand model and sample selectivity issues.
    Keywords: International drinking patterns; price sensitivity of consumption of beer, wine and spirits; alcohol demand system; alcohol and utility
    JEL: D12 C30
    Date: 2019
  16. By: Bjerre-Nielsen, Andreas
    Abstract: This paper investigates endogenous network formation by heterogeneous agents. The agents' types determine the value of linking and we incorporate spillovers as utility from indirect connections. We provide sufficient conditions for a class of networks with sorting to be stable for low to moderate spillovers; with only two types these networks are the unique pairwise stable ones. We also show that this sorting is suboptimal for moderate to high spillovers despite otherwise obeying the conditions for sorting in Becker 1973. This shows that in our sorted networks a tension between stability and efficiency is present. We analyze a policy tool to mitigate suboptimal sorting.
    Date: 2019–09–12
  17. By: Epper, Thomas; Fehr, Ernst; Fehr-Duda, Helga; Thustrup Kreiner, Claus; Dreyer Lassen, David; Leth-Petersen, Søren; Nytoft Rasmussen, Gregers
    Abstract: This paper documents a large association between individuals’ time discounting in incentivized experiments and their positions in the real-life wealth distribution derived from Danish highquality administrative data for a large sample of middle-aged individuals. The association is stable over time, exists through the wealth distribution and remains large after controlling for education, income profile, school grades, initial wealth, parental wealth, credit constraints, demographics, risk preferences and additional behavioral parameters. Our results suggest that savings behavior is a driver of the observed association between patience and wealth inequality as predicted by standard savings theory.
    Keywords: Wealth inequality, savings behavior, time discounting, experimental methods, administrative data
    JEL: C91 D31 E21
    Date: 2019–11

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