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on Utility Models and Prospect Theory |
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Issue of 2020‒01‒20
24 papers chosen by |
| By: | Chichilnisky, Graciela (Columbia University); Hammond, Peter J. (University of Warwick); Stern, Nicholas (London School of Economics) |
| Abstract: | Ramsey famously condemned discounting “future enjoyments” as “ethically indefensible”. Suppes enunciated an equity criterion which, when social choice is utilitarian, implies giving equal weight to all individuals’ utilities. By contrast, Arrow (1999a, b) accepted, perhaps reluctantly, what he called Koopmans’ (1960) “strong argument” implying that no equitable preference ordering exists for a sufficiently unrestricted domain of infinite utility streams. Here we derive an equitable utilitarian objective for a finite population based on a version of the Vickrey–Harsanyi original position, where there is an equal probability of becoming each person. For a potentially infinite population facing an exogenous stochastic process of extinction, an equitable extinction biased original position requires equal conditional probabilities, given that the individual’s generation survives the extinction process. Such a position is well-defined if and only if survival probabilities decline fast enough for the expected total number of individuals who can ever live to be finite. Then, provided that each individual’s utility is bounded both above and below, maximizing expected “extinction discounted” total utility — as advocated, inter alia, by the Stern Review on climate change — provides a coherent and dynamically consistent equitable objective, even when the population size of each generation can be chosen. |
| Keywords: | Discounting, time perspective, fundamental preferences, fundamental utilitarianism, consequentialization, Vickrey–Harsanyi original position, Suppes equity, intergenerational equity, sustainable preferences, extinction discounting JEL Classification: D63, D70, D90, Q54, Q56 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:cge:wacage:451&r=all |
| By: | Kim, Minseong |
| Abstract: | This comment paper briefly goes over what ergodicity economics in Peters (2019) is about, why economists reject ergodicity economics and what we can get out of this dispute. 1) The core arguments of ergodicity economics rely on constructing an ergodic observable, and thus relies on a justification of why an observable needs to be ergodic. 2) The modern foundation of expected utility theory is about revealed preference theory, and thus criticisms of economics solely based on cardinal utility are heavily misguided. 3) The real question thus lies on whether revealed preference theory really captures actual utility of an agent. |
| Date: | 2019–12–07 |
| URL: | http://d.repec.org/n?u=RePEc:osf:osfxxx:7gm8a&r=all |
| By: | Oliver de Groot; Alexander W. Richter; Nathanial A. Throckmorton |
| Abstract: | This paper shows the recent success of valuation risk (time-preference shocks in EpsteinZin utility) in resolving asset pricing puzzles rests sensitively on an undesirable asymptote that occurs because the preference specification fails to satisfy a key restriction on the weights in the Epstein-Zin time-aggregator. When we revise the preferences to satisfy the restriction in a simple asset pricing model, the puzzles resurface. However, when estimating a sequence of Bansal-Yaron long-run risk models, we find valuation risk under the revised specification consistently improves the ability of the models to match asset price and cash-flow dynamics. |
| Keywords: | Epstein-Zin Utility; Asset Pricing; Equity Premium Puzzle; Risk-Free Rate Puzzle |
| JEL: | D81 G12 |
| Date: | 2019–07 |
| URL: | http://d.repec.org/n?u=RePEc:liv:livedp:201904&r=all |
| By: | Ilke Aydogan; Loic Berger; Valentina Bosetti |
| Abstract: | We report on a laboratory experiment measuring the preferences of a unique pool of risk professionals over various sources of uncertainty that entail different degrees of complexity. We then compare these preferences with those of a control group composed of social science students to obtain a deeper understanding of the mechanisms driving behaviors under risk and ambiguity. We find that (1) ambiguity aversion is robust to subjects’ degree of sophistication in probabilistic reasoning and background. (2) An association exists between attitudes toward ambiguity and compound risk for students/less sophisticated subjects, and is mainly explained by their attitudes toward complexity. Such an association does not exist for risk professionals/more sophisticated subjects. (3) The failure to reduce compound risk emerges as a sufficent, but not necessary, condition for ambiguity non-neutrality. These findings suggest that decision making under ambiguity cannot be reduced to decision making under risk. Keywords: Ambiguity aversion, reduction of compound lotteries, non-expected utility, model uncertainty, model misspecification JEL Codes: D81 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:igi:igierp:653&r=all |
| By: | Mark L. Egan; Alexander MacKay; Hanbin Yang |
| Abstract: | We use a revealed-preference approach to estimate investor expectations of stock market returns. Using data on demand for index funds that follow the S&P 500, we develop and estimate a model of investor choice to flexibly recover the time-varying distribution of expected returns. Despite the fact that they are generated from a different method (realized choices) and a different population, our quarterly estimates of investor expectations are positively and significantly correlated with the leading surveys used to measure stock market expectations. Our estimates suggest that investor expectations are heterogeneous, extrapolative, and persistent. Following a downturn, investors become more pessimistic on average, but there is also an increase in disagreement among participating investors. Our analysis is facilitated by the prevalence of “leveraged” funds, i.e., funds that provide the investor with a menu over leverage. The menu of choices allows us to separately estimate expectations and risk aversion. We estimate that the availability of these funds provides investors with significant (ex ante) consumer surplus. |
| JEL: | D12 D81 D84 G11 L0 |
| Date: | 2020–01 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:26608&r=all |
| By: | Persichina, Marco |
| Abstract: | This paper analyses the effects of myopic and present-biased preferences on the welfare of a naive agent when she is engaged in an intertemporal harvesting activity from a stock of renewable resources. The analysis is conducted by taking into account also the nature of present-biased behaviors as phenomena that is derived from a dual system of discounting and of response to short and long-term stimuli. In the task of harvesting from a stock of renewable resources, the present biased preferences of a naive agent create a conflict between the long run benefit of the agent and the short run desire. Thus, this paper demonstrates and argues that in the decision-making, which involves intertemporal choices in renewable resources management, the prevalence of naive behavior, strongly influenced by the emotional-affective system, can lead to a reduction in the overall utility enjoyed by the individual due to the present bias. |
| Keywords: | Present bias, naive agent, intertemporal choice, harvesting, dual system discounting, agent’s welfare, instant utility. |
| JEL: | D03 D90 Q20 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:97986&r=all |
| By: | Erhan Bayraktar; Leonid Dolinskyi; Yan Dolinsky |
| Abstract: | In this paper we study utility maximization with proportional transaction costs. Assuming extended weak convergence of the underlying processes we prove the convergence of the corresponding utility maximization problems. Moreover, we establish a limit theorem for the optimal trading strategies. The proofs are based on the extended weak convergence theory developed in [1] and the Meyer--Zheng topology introduced in [19]. |
| Date: | 2019–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1912.08863&r=all |
| By: | Andrea Civelli; Cary Deck; Antonella Tutino |
| Abstract: | We present a model where rationally inattentive agents decide how much to save while imperfectly tracking interest rate changes. Suitable assumptions on agents’ preferences and interest rate distribution allow us to derive testable theoretical predictions and their implications for monetary policy. We probe these predictions using a laboratory experiment with induced inattention that closely reflects the theoretical assumptions. We find that, empirically, the laboratory data corroborates the results of the theoretical model. In particular, we show that experimental subjects respond to changes in the interest rate policy environment with: (1) a decrease in savings when the utility gain from savings does not compensate for the cognitive cost of tracking the interest rate; (2) more informed and deliberate consumption/investment choices when the monetary authority stabilizes the economy by lowering the volatility of the policy rate, implementing a version of Delphic forward guidance; (3) a slight decrease in information processing but no behavioral changes in consumption when the monetary authority signals current monetary policy stance, implementing a version of Odyssean forward guidance; (4) a sizable decrease in investment when their perception of the outlook deteriorates. These experimental and theoretical findings agree with the empirical literature on the effect of monetary policy on households’ consumption behavior in U.S. data and abroad. |
| Keywords: | Rational Inattention; Experimental Evidence; Informational Processing Capacity; Consumption |
| JEL: | C91 D11 D8 E20 |
| Date: | 2019–12–19 |
| URL: | http://d.repec.org/n?u=RePEc:fip:feddwp:86730&r=all |
| By: | Jorge Vasquez (Smith University; Group for Research in Applied Economics (GRAPE)); Marek Weretka (Group for Research in Applied Economics (GRAPE); University of Wisconsin-Madison) |
| Abstract: | According to psychology, affective empathy is one of the key processes governing human interactions. It refers to the automatic transmission and diffusion of emotions in response to others' emotions, which gives rise to emotional contagion. Contrary to other forms of empathy, affective empathy has received little attention in economics. In this paper, we augment the standard game-theoretic framework by allowing players to affectively empathize. Players' utility functions depend not only on the strategy prole being played, but also on the realized utilities of other players. Thus, players' realized utilities are interdependent, capturing emotional contagion. We offer a solution concept for these empathetic games and show that the set of equilibria is non-empty and, generically, finite. Motivated by psychological evidence, we analyze sympathetic and antipathetic games. In the former, players' utilities increase in others' realized utilities, capturing unconditional friendship; whereas in the latter the opposite holds, resembling hostility. |
| Keywords: | affective empathy, emotional contagion, Interdependent utilities, non-paternalistic preferences |
| JEL: | D64 D90 D91 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:fme:wpaper:36&r=all |
| By: | Levon Barseghyan (Institute for Fiscal Studies); Francesca Molinari (Institute for Fiscal Studies and Cornell University); Matthew Thirkettle (Institute for Fiscal Studies) |
| Abstract: | This paper is concerned with learning decision makers' (DMs) preferences using data on observed choices from a fi nite set of risky alternatives with monetary outcomes. We propose a discrete choice model with unobserved heterogeneity in consideration sets (the collection of alternatives considered by DMs) and unobserved heterogeneity in standard risk aversion. In this framework, stochastic choice is driven both by different rankings of alternatives induced by unobserved heterogeneity in risk preferences and by different sets of alternatives considered. We obtain sufficient conditions for seminonparametric point identi fication of both the distribution of unobserved heterogeneity in preferences and the distribution of consideration sets. Our method yields an estimator that is easy to compute and that can be used in markets with a large number of alternatives. We apply our method to a dataset on property insurance purchases. We fi nd that although households are on average strongly risk averse, they consider lower coverages more frequently than higher coverages. Finally, we estimate the monetary losses associated with limited consideration in our application. |
| Keywords: | discrete choice, limited consideration, semi-nonparametric identifi cation |
| Date: | 2019–02–18 |
| URL: | http://d.repec.org/n?u=RePEc:ifs:cemmap:08/19&r=all |
| By: | Spencer Bastani; Thomas Giebe; Oliver Gürtler |
| Abstract: | We develop a general framework to study contests, containing the well-known models of Tullock (1980) and Lazear & Rosen (1981) as special cases. The contest outcome depends on players’ effort and skill, the latter being subject to symmetric uncertainty. The model is tractable, because a symmetric equilibrium exists under general assumptions regarding production technologies and skill distributions. We construct a link between our contest model and expected utility theory and exploit this link to revisit important comparative statics results of contest theory and show how these can be overturned. Finally, we apply our results to study optimal workforce composition. |
| Keywords: | contest theory, symmetric equilibrium, heterogeneity, risk, decision theory |
| JEL: | C72 D74 D81 J23 M51 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_7993&r=all |
| By: | Watanabe, Minoru; Miyake, Yusuke; Yasuoka, Masaya |
| Abstract: | We build a standard overlapping generations model with endogenous fertility and involuntary unemployment. Being different from a log utility function, the capital income tax affects saving at the model of constant relative risk-averse utility function (CRRA function). In the parameter condition, to have the case of non-substitution between consumption in different periods, the capital income tax raises saving to compensate for consumption in the future. Then, results show that a capital income tax improves fertility and unemployment with no social security system. |
| Keywords: | capital income tax, fertility, unemployment |
| JEL: | J13 J60 |
| Date: | 2019–12–20 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:97721&r=all |
| By: | Tiziana Assenza; Alberto Cardaci; Domenico Delli Gatti |
| Abstract: | By means of a laboratory experiment, we show that, contrary to standard consumer theory, financially equivalent balance sheet profiles may be perceived as non fungible in a controlled frictionless environment with no probabilistic attributes. A large majority of subjects indeed have a bias in the perception of wealth, such that balance sheet composition matters: for a given net worth with values of assets and debt that are financially certain and risk-free, a greater asset-debt ratio implies greater perceived wealth. The predominance of this bias is explained by low cognitive sophistication and great inattention. Moreover, biased subjects are less patient, less debt averse, more likely to increase spending out of unexpected gains and report greater propensities to consume. A standard optimal consumption choice model, enriched with a rational but inattentive agent à la Gabaix (2014, 2019), aligns our key experimental findings. |
| Keywords: | perceived wealth, cognitive sophistication, behavioral inattention, laboratory experiment, household debt, consumption |
| JEL: | C91 D91 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_7992&r=all |
| By: | Shah, K.K; Ramos-Goñi, J.M; Kreimeier, S.; Devlin, N.J |
| Abstract: | To date there have been no value sets to support the use of the EQ-5D-Y in cost-utility analysis. Discrete choice experiments (DCEs) can be used to obtain values on a latent scale, but these values require anchoring at 0 = dead to meet the conventions of quality-adjusted life year (QALY) estimation. This Research Paper describes a study in which four stated preference methods for anchoring EQ-5D-Y values were compared - visual analogue scale, DCE (with a duration attribute), lag-time TTO and the recently developed 'location-of-dead' (LOD) element of the personal utility function approach. A sample of adult members of the UK general public valued both EQ-5D-3L health states from an adult perspective (considering their own health) and EQ-5D-Y health states from a child perspective (considering the health of a 10-year-old child). Overall, respondents gave lower values under the adult perspective compared to child perspective, with some variation across methods. Values for health state 33333 (the worst health state defined by the EQ-5D-3L and EQ-5D-Y descriptive systems) tended to be negative for the adult perspective and closer to 0 for the child perspective. The paper presents potential criteria for selecting a preferred anchoring method, and discusses the decision-making circumstances under which utilities and QALY estimates for children and adults need to be commensurate in order to achieve allocative efficiency. |
| Keywords: | Measuring and valuing outcomes |
| JEL: | I1 |
| Date: | 2020–01–01 |
| URL: | http://d.repec.org/n?u=RePEc:ohe:respap:002235&r=all |
| By: | Tommaso Denti; Massimo Marinacci; Aldo Rustichini |
| Abstract: | We study the relation between two alternative representations for the cost of acquiring information: a cost that depends on the experiment that the decision maker performs, as in Wald's statistical decision theory, and a cost that depends on the distribution of posterior beliefs that the decision maker ends up with, as in Sims' theory of rational inattention. We show that in many cases of interests, such as Sims' entropy cost, the two representations are inconsistent with each other. Our main contribution is a systematic analysis of experimental cost functions, which are cost functions over distributions of posteriors that are consistent with an underlying model of costly experimentation. We also develop a regularization scheme to bridge the gap between experimental and non-experimental cost functions. |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:igi:igierp:657&r=all |
| By: | Dariusz Zawisza |
| Abstract: | We solve robust optimization problem and show the example of the market model for which the worst case measure is not a martingale measure. In our model the instantaneous interest rate is determined by the Hull-White model and the investor employs the HARA utility to measure his satisfaction.To protect against the model uncertainty he uses the worst case measure approach. The problem is formulated as a stochastic game between the investor and the market from the other side. PDE methods are used to find the saddle point and the precise verification argument is provided. |
| Date: | 2020–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2001.01998&r=all |
| By: | Monika Bolek (Faculty of Economics and Sociology, University of Lodz); Rafal Wolski (Faculty of Economics and Sociology, University of Lodz) |
| Abstract: | The goal of this paper is to discuss the rationality of market professionals and analyze the behavioral biases they are subject to. It is assumed that less biased decisions are representing more rational behavior. Analyzing the groups of finance professionals: investment fund managers and finance students it has been proven, that managers are more rational than students and their decisions are less biased. The homo oeconomicus idea in relation to the professionals operating on a capital market is analyzed in the light of economic theories evolution together with the behavioral finance findings. |
| Keywords: | rationality, professionals, financial market, behavioral finance |
| JEL: | E03 G02 |
| Date: | 2019–10 |
| URL: | http://d.repec.org/n?u=RePEc:sek:iacpro:9912031&r=all |
| By: | Hyungbin Park |
| Abstract: | This paper investigates the large-time asymptotic behavior of the sensitivities of cash flows. In quantitative finance, the price of a cash flow is expressed in terms of a pricing operator of a Markov diffusion process. We study the extent to which the pricing operator is affected by small changes of the underlying Markov diffusion. The main idea is a partial differential equation (PDE) representation of the pricing operator by incorporating the Hansen--Scheinkman decomposition method. The sensitivities of the cash flows and their large-time convergence rates can be represented via simple expressions in terms of eigenvalues and eigenfunctions of the pricing operator. Furthermore, compared to the work of Park (Finance Stoch. 4:773-825, 2018), more detailed convergence rates are provided. In addition, we discuss the application of our results to three practical problems: utility maximization, entropic risk measures, and bond prices. Finally, as examples, explicit results for several market models such as the Cox--Ingersoll--Ross (CIR) model, 3/2 model and constant elasticity of variance (CEV) model are presented. |
| Date: | 2019–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1912.03404&r=all |
| By: | Sebastian Butschek; Roberto González Amor; Patrick Kampkötter; Dirk Sliwka |
| Abstract: | We study the performance effects of payment schemes for freelancers offering services on an online platform in an RCT. Under the initial scheme, the firm pays workers a pure sales commission. The intervention reduces the commission rate and adds a fixed payment per processed order to insure workers against earnings risk. Our experiment tests predictions from a formal model on labor supply and performance for individuals with different degrees of risk aversion and intrinsic motivation for the task. The treatment did not affect labor supply and even though the commission rate was reduced by 50% we find no sizeable loss in sales per order. However, there is strong evidence for heterogeneous treatment effects. The treatment reduced performance for less intrinsically motivated workers. For more intrinsically motivated workers, however, we observe the opposite pattern as performance increased even though commission rates were reduced. |
| Keywords: | incentives, risk aversion, intrinsic motivation, sales compensation, multitasking, field experiment, gig economy, on demand economy, platform economy |
| JEL: | D23 J33 M52 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_7983&r=all |
| By: | Christoph March; Marco Sahm |
| Abstract: | We investigate overlapping contests in multi-divisional organizations in which an individual’s effort simultaneously determines the outcome of several contests on different hierarchical levels. We show that individuals in smaller units are advantaged in the grand (organization-wide) contest for two reasons: First, the incentive to free-ride is smaller in inter-divisional contests. Second, competition in the intra-divisional contest is less fierce. Both effects induce a higher marginal utility of effort provision. We test the model in a laboratory experiment and confirm its main predictions. Our results have important consequences for the provision of incentives in organizations and the design of sports competitions. |
| Keywords: | contest, rent-seeking, hierarchy, teams, experiment |
| JEL: | C72 C92 D72 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_7994&r=all |
| By: | Sibert, Cara Elisabeth |
| Abstract: | A study of the research practices surrounding loss aversion and the endowment effect. |
| Date: | 2018–10–08 |
| URL: | http://d.repec.org/n?u=RePEc:osf:osfxxx:en9qj&r=all |
| By: | Stout, Lynn; Library, Cornell |
| Abstract: | 3 Legal Theory 227 (1997) Rational expectations models have become a staple of economic theory and the basis for a Nobel Prize. This article argues that rational expectations analysis suffers from potentially fatal flaws that seriously undermine its value in understanding many market phenomena. Using the example of financial markets, the article illustrates how the rational expectations approach has worked to obscure, rather than to illuminate, our understanding of speculation and speculative markets. This misguidance raises problems for law and policy. |
| Date: | 2018–06–25 |
| URL: | http://d.repec.org/n?u=RePEc:osf:lawarx:aq63c&r=all |
| By: | Ohdoi, Ryoji; Futagami, Koichi |
| Abstract: | This study proposes a model of non-unitary time discounting and examines its welfare implications. A key feature of our model lies in the disparity of time discounting between multiple distinct goods, which induces an individual's preference reversals even though she normally discounts her future utilities for each good. After characterizing the time-consistent decision-making by such an individual in a general setting, we compare welfare achieved in the market economy and welfare in the planner's allocation from the perspective of all selves across time. Under certain situations, the selves in early periods strictly prefer the social planner's allocation, whereas the selves in future periods strictly prefer the market equilibrium. Therefore, the welfare implications of our model are quite different from those in the canonical discounting model and in models of other time-inconsistent preferences. |
| Keywords: | Non-unitary time discounting; Time inconsistency; Time-consistent tax policy. |
| JEL: | E21 H21 O41 |
| Date: | 2019–11–29 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:97346&r=all |
| By: | Harold L. Cole (University of Pennsylvania); Dirk Krueger (University of Pennsylvania); George J. Mailath (University of Pennsylvania); Yena Park (University of Rochester) |
| Abstract: | We analyze e?cient risk-sharing arrangements when coalitions may deviate. Coalitions form to insure against idiosyncratic income risk. Self-enforcing contracts for both the original coalition and any deviating coalition rely on a belief in future cooperation, and we treat the contracting conditions of original and deviating coalitions symmetrically. We show that better belief coordination (higher social capital) tightens incentive constraints since it facilitates both the formation of the original as well as a deviating coalition. As a consequence, the payo? of successfully formed coalitions might be declining in the degree of belief coordination and equilibrium allocations might feature resource burning or utility burning. |
| Keywords: | Financial Coalition, Limited Enforcement, Risk Sharing, Coalition-Proof Equi-librium |
| JEL: | E21 G22 D11 D91 |
| Date: | 2019–01–08 |
| URL: | http://d.repec.org/n?u=RePEc:pen:papers:20-002&r=all |