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on Utility Models and Prospect Theory |
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Issue of 2020‒02‒03
twenty-one papers chosen by |
| By: | Thomas Gomez; Giulia Piccillo |
| Abstract: | We propose a heuristic switching model of an asset market where the agents’ choice of heuristic is consistent with their individual risk aversion. They choose between a fundamentalist and a trend-following rule to form expectations about the price of a risky asset. Given their risk aversion, agents make a deterministic trade-off between mean and variance both in choosing a forecasting heuristic and determining the number of risky assets to buy. Heterogeneous risk preferences can lead to diverse choices of heuristic. Using empirical estimates for the distribution of risk aversion, simulations show that the resulting time-varying heterogeneity of expectations can give rise to chaotic dynamics: irregular booms and busts in the asset price without exogenous shocks. Small, stochastic price shocks lead to larger asset price bubbles, and can make stable solutions explosive. We prove that a representative agent cannot capture our model. |
| Keywords: | heterogeneous risk aversion, bounded rationality, heterogeneous expectations, heuristic switching, asset pricing |
| JEL: | D81 D84 G11 G12 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_8003&r=all |
| By: | Martin F. Quaas; Stefan Baumgärtner; Moritz A. Drupp; Jasper N. Meya |
| Abstract: | We characterize intertemporal utility functions over heterogeneous goods that feature (i) a constant elasticity of substitution between goods at each point in time and (ii) a constant intertemporal elasticity of substitution for at least one of the goods. We find that a standard (stationary) intertemporal utility function is consistent with these two properties if and only if it either is of the intertemporal constant elasticity of substitution (ICES) form, that is, if all elasticities of substitution are identical, or if the instantaneous utility function is Cobb-Douglas. We also characterize the families of standard intertemporal utility functions that feature either (i) or (ii), but not the respective other property. The ICES utility function offers a simple and consistent solution for applications that use constant good-specific intertemporal substitutability. This is, for example, relevant for dual discounting of market and non-market goods. |
| Keywords: | substitutability, CES, CIES, intertemporal utility, non-market goods |
| JEL: | D61 Q51 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_7999&r=all |
| By: | Alev Meral |
| Abstract: | In this paper, we search for optimal portfolio strategies in the presence of various risk measure that are common in financial applications. Particularly, we deal with the static optimization problem with respect to Value at Risk, Expected Loss and Expected Utility Loss measures. To do so, under the Black- Scholes model for the financial market, Martingale method is applied to give closed-form solutions for the optimal terminal wealths; then via representation problem the optimal portfolio strategies are achieved. We compare the performances of these measures on the terminal wealths and optimal strategies of such constrained investors. Finally, we present some numerical results to compare them in several respects to give light to further studies. |
| Date: | 2019–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1912.09573&r=all |
| By: | Andrea Civelli (University of Arkansas, Walton College of Business, Department of Economics); Cary Deck (University of Alabama; Economic Science Institute, Chapman University); Antonella Tutino (Federal Reserve Bank of Dallas) |
| Abstract: | We study the response of consumption and saving decisions of rationally inattentive individuals to changes in monetary policy in the laboratory. First, we theoretically characterize the choices of a rationally inattentive agent processing information about the interest rate. Then, we design an experiment with induced inattention to test for the predictions of the model, contrasting them to the full information case. Consistent with the predictions, experimental subjects (a) increase attention when utility gains exceed cognitive costs of tracking the policy rate and decrease savings when their perceived economic outlook deteriorates; (b) respond to Delphic, but not Odyssean, forms of forward guidance. These ?ndings agree with recent empirical evidence on monetary policy e?ects on consumption behavior in U.S. and internationally. |
| Keywords: | Rational Inattention; Experimental Evidence' Information Processing Capacity; Consumption |
| JEL: | C91 D11 D8 E20 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:chu:wpaper:20-02&r=all |
| By: | Schlag, Karl; Tremewan, James |
| Abstract: | We present a method for eliciting beliefs about probabilities when multiple realisations of an outcome are available, the "frequency'' method. The method is applicable for any reasonable utility function. Unlike existing techniques that account for deviations from risk-neutrality, this method is highly transparent to subjects and easy to implement. Rather than identifying point beliefs these methods identify bounds on beliefs, thus trading off precision for generality and simplicity. An experimental comparison of this method and a popular alternative, the Karni method, shows that subjects indeed find the frequency method easier to understand. Significantly, we show that confusion due to the complexity of the Karni method leads to less cognitively able subjects erroneously stating a belief of 50%, a bias not present in the frequency method. |
| Keywords: | Belief elicitation; experiment |
| JEL: | C91 |
| Date: | 2020–01–17 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:98187&r=all |
| By: | Calleja, Pedro (Departament de Matemàtica Econòmica); Llerena, Francesc (Departament de Gestió dEmpreses); Sudhölter, Peter (Department of Business and Economics) |
| Abstract: | We introduce the constrained egalitarian surplus-sharing rule fCE, which distributes an amount of a divisible resource so that the poorer agents’ resulting payoffs become equal but not larger than any remaining agent’s status quo payoff. We show that fCE is characterized by Pareto optimality, nonnegativity, path independence, and less first, a new property requiring that an agent does not gain if her status quo payoff exceeds that of another agent by the surplus. We provide two additional characterizations weakening less first and employing consistency, a classical invariance property with respect to changes of population. We investigate the effects of egalitarian principles in the setting of transferable utility (TU) games. A single-valued solution for TU games is said to support constrained welfare egalitarianism if it distributes any increment of the worth of the grand coalition according to fCE. We show that the set of Pareto optimal single-valued solutions that support fCE is characterized by means of aggregate monotonicity and bounded pairwise fairness, resembling less first. |
| Keywords: | Surplus-sharing problem; egalitarianism; Lorenz domination; TU game |
| JEL: | C71 |
| Date: | 2020–01–27 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:sdueko:2020_001&r=all |
| By: | Gaston Clément Nyassoke Titi (Université de Douala); Jules Sadefo Kamdem (MRE - Montpellier Recherche en Economie - UM - Université de Montpellier, UG - Université de Guyane); Louis Fono (Université de Douala) |
| Abstract: | In this paper we study the problem of optimal fishing for regime switching, which may be regarded as sequential optimal problem with changes of regimes. The growth dynamics of a given fish species is described by the differential stochastic logistic model in which we take into account two states: prior or during floods and after. The resulting dynamic programming principle leads to a system of variational inequalities, by means of viscosity solutions approach, we prove the existence and uniqueness of the value functions. Then numerical approximation is used to answer the question: what is the optimal fishing effort for a sustainable fishery? |
| Keywords: | regime switching,floods,crra utility,logistic growth,mean-reverting prices,viscosity solution,Howard's algorithm |
| Date: | 2020–01–09 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-02433395&r=all |
| By: | Brad M. Barber; Adair Morse; Ayako Yasuda |
| Abstract: | We document that investors derive nonpecuniary utility from investing in dual-objective VC funds, thus sacrificing returns. Impact funds earn 4.7 percentage points (ppts) lower IRRs ex post than traditional VC funds. In random utility/willingness-to-pay (WTP) models investors accept 2.5-3.7 ppts lower IRRs ex ante for impact funds. The positive WTP result is robust to fund access rationing and investor heterogeneity in fund expected returns. Development organizations, foundations, financial institutions, public pensions, Europeans, and UNPRI signatories have high WTP. Investors with mission objectives and/or facing political pressure exhibit high WTP; those subject to legal restrictions (e.g., ERISA) exhibit low WTP. |
| JEL: | A13 G11 G23 G24 Z1 |
| Date: | 2019–12 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:26582&r=all |
| By: | Hannu Salonen (University of Turku); Mitri Kitti (University of Turku) |
| Abstract: | We give a proof of the existence of a Nash equilibrium forn-personnormal form games when each player’s utility function is continuousw.r.t. strategy profiles, and concave and differentiable w.r.t. his ownstrategy. The proof uses only elementary mathematical tools such asmathematical induction. We show that this equilibrium existence re-sult is sufficiently general to imply the Brouwer Fixed Point Theorem.The Kakutani Fixed Point Theorem is obtained as a corollary by usingstandard techniques. |
| Keywords: | Nash equilibrium, fixed-point theorem |
| JEL: | C72 |
| Date: | 2019–12 |
| URL: | http://d.repec.org/n?u=RePEc:tkk:dpaper:dp131&r=all |
| By: | Geert Ridder; Shuyang Sheng |
| Abstract: | This paper develops estimation methods for network formation models using observed data from a single large network. The model allows for utility externalities from friends of friends and friends in common, so the expected utility is nonlinear in the link choices of an agent. We propose a novel method that uses the Legendre transform to express the expected utility as a linear function of the individual link choices. This implies that the optimal link decision is that for an agent who myopically chooses to establish links or not to the other members of the network. The dependence between the agent's link choices is through an auxiliary variable. We propose a two-step estimation procedure that requires weak assumptions on equilibrium selection, is simple to compute, and has consistent and asymptotically normal estimators for the parameters. Monte Carlo results show that the estimation procedure performs well. |
| Date: | 2020–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2001.03838&r=all |
| By: | Franz Dietrich (CNRS - Centre National de la Recherche Scientifique, PSE - Paris School of Economics, CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Christian List (LSE - London School of Economics and Political Science) |
| Abstract: | Agents are often assumed to have degrees of belief ("credences") and also binary beliefs ("beliefs simpliciter"). How are these related to each other? A much-discussed answer asserts that it is rational to believe a proposition if and only if one has a high enough degree of belief in it. But this answer runs into the "lottery paradox": the set of believed propositions may violate the key rationality conditions of consistency and deductive closure. In earlier work, we showed that this problem generalizes: there exists no local function from degrees of belief to binary beliefs that satisfies some minimal conditions of rationality and non-triviality. "Locality" means that the binary belief in each proposition depends only on the degree of belief in that proposition, not on the degrees of belief in others. One might think that the impossibility can be avoided by dropping the assumption that binary beliefs are a function of degrees of belief. We prove that, even if we drop the "functionality" restriction, there still exists no local relation between degrees of belief and binary beliefs that satisfies some minimal conditions. Thus functionality is not the source of the impossibility; its source is the condition of locality. If there is any non-trivial relation between degrees of belief and binary beliefs at all, it must be a "holistic" one. We explore several concrete forms this "holistic" relation could take. |
| Date: | 2020–01–08 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:halshs-02431882&r=all |
| By: | Bergantiños, Gustavo; Navarro-Ramos, Adriana |
| Abstract: | This paper considers agglomeration economies. A new firm is planning to open a plant in a country divided into several regions. Each firm receives a positive externality if the new plant is located in its region. In a decentralized mechanism, the plant would be opened in the region where the new firm maximizes its individual benefit. Due to the externalities, it could be the case that the aggregated utility of all firms is maximized in a different region. Thus, the firms in the optimal region could transfer something to the new firm in order to incentivize it to open the plant in that region. We propose two rules that provide two different schemes for transfers between firms already located in the country and the newcomer. The first is based on cooperative game theory. This rule coincides with the nucleolus and the t-value of the associated cooperative game. The second is defined directly. We provide axiomatic characterizations for both rules. We characterize the core of the cooperative game. We prove that both rules belong to the core. |
| Keywords: | game theory, core, axiomatic characterization, agglomeration economies. |
| JEL: | C71 |
| Date: | 2020–01–13 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:98121&r=all |
| By: | Fugger, Nicolas; Gillen, Philippe; Riehm, Tobias |
| Abstract: | We show that it is beneficial for a buyer to conduct a multi-stage mechanism if bidders are loss averse. In a first step, we derive a revenue equivalence principle. Fixing the multi-stage structure, the revenue is independent of the chosen payment rule. Secondly, we introduce a simple two-stage mechanism which always leads to a decrease in procurement costs compared to any single-stage auction. Finally we derive the optimal efficient two-stage mechanism. |
| Keywords: | Auctions,Experiment,Loss aversion,Preferences |
| JEL: | D44 D47 D90 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:zewdip:19060&r=all |
| By: | Jaqueson K. Galimberti (School of Economics, Auckland University of Technology) |
| Abstract: | This note evaluates how adaptive learning agents weigh different pieces of information when forming expectations with a recursive least squares algorithm. The analysis is based on a new and more general non-recursive representaion of the learning algorithm, namely, a penalized weighted least squares estimator, where a penalty term accounts for the effects of the learning initials. The paper then draws behavioral implications of diferent specifications of the learning mechanism, such as the cases with decreasing-, constant-, regime-switching, and age-dependent gains. The latter is shown to imply the emergence of "dormant memories" as the agents get old. |
| Keywords: | bounded rationality, expectations, adaptive learning, memory |
| JEL: | D83 D84 D90 E37 C32 C63 |
| Date: | 2020–01 |
| URL: | http://d.repec.org/n?u=RePEc:aut:wpaper:202004&r=all |
| By: | Hakobyan, Zaruhi; Koulovatianos, Christos |
| Abstract: | Differential games of common resources that are governed by linear accumulation constraints have several applications. Examples include political rent-seeking groups expropriating public infrastructure, oligopolies expropriating common resources, industries using specific common infrastructure or equipment, capital-flight problems, pollution, etc. Most of the theoretical literature employs specific parametric examples of utility functions. For symmetric differential games with linear constraints and a general time-separable utility function depending only on the player's control variable, we provide an exact formula for interior symmetric Markovian-strategies. This exact solution, (a) serves as a guide for obtaining some new closed-form solutions and for characterizing multiple equilibria, and (b) implies that, if the utility function is an analytic function, then the Markovian strategies are analytic functions, too. This analyticity property facilitates the numerical computation of interior solutions of such games using polynomial projection methods and gives potential to computing modified game versions with corner solutions by employing a homotopy approach. |
| Keywords: | differential games,endogenous growth,tragedy of the commons,Lagrange-d'Alembert equation,analytic functions |
| JEL: | C73 C61 D74 E0 O40 O44 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:cfswop:638&r=all |
| By: | Holzmeister, Felix (University of Innsbruck); Holmén, Martin; Kirchler, Michael; Stefan, Matthias; Wengström, Erik (Lund University) |
| Abstract: | We run an online experiment with 408 finance professionals (money managers) and 550 subjects from the general population in Sweden (clients). We examine drivers of clients' delegation decisions, differences in decision-making quality between both groups, and professionals' ability to implement investment portfolios that suit the clients' risk attitudes. We find that clients' trust in money managers increases the likelihood of delegating their investment decisions, whereas decision-making quality is associated with a decrease. We further show that decision-making quality of finance professionals is not significantly higher compared to their clients' when controlling for risk taking. Finally, we observe high variability among professionals' perception of delegated risk levels and overlaps in portfolio risk across self-reported risk-levels of clients. This finding indicates that communicating risk between clients and professionals constitutes a potential pitfall in delegated investment decisions. |
| Date: | 2019–12–03 |
| URL: | http://d.repec.org/n?u=RePEc:osf:osfxxx:3umdf&r=all |
| By: | Eguren-Martin, Fernando (Bank of England); Meldrum, Andrew (Federal Reserve Board); Yan, Wen (Barclays Capital) |
| Abstract: | We use a no-arbitrage term structure model of equity yields computed from the prices of dividend swaps to estimate the yields on hypothetical bonds with cash-flows indexed to the level of US GDP. This provides a novel approach for estimating the possible relative cost of conventional and GDP-linked bonds, which is likely to be of interest to sovereigns considering the case for issuing GDP-linked debt. Our model predicts that US GDP-linked bonds would typically have yields lower than those on conventional Treasury bonds with the same maturity in our sample from 2010 to 2017. Positive expected future GDP growth lowers the yield on GDP-linked bonds relative to conventional bonds, which typically more than offsets the estimated GDP risk premium demanded by investors for holding GDP risk. These risk premia decrease with maturity,with unconditional averages falling in absolute value from 7 percentage points at the short-end of the curve to 1 percentage points at the 10-year horizon. |
| Keywords: | Affine term structure model (ATSM); bond yield; equity yield; risk premia; dividend swaps; GDP-linked bonds; spanned macroeconomic factors. |
| JEL: | E43 G01 H63 |
| Date: | 2020–01–10 |
| URL: | http://d.repec.org/n?u=RePEc:boe:boeewp:0849&r=all |
| By: | Brice Corgnet (Emlyon Business School); Cary Deck (University of Alabama; Chapman University); Mark DeSantis (Chapman University); Kyle Hampton (Chapman University); Erik O. Kimbrough (Chapman University) |
| Abstract: | The ability of markets to aggregate dispersed information is a cornerstone of economics and finance. In a seminal experiment, Plott and Sunder (1988) offer support for the rational expectations hypothesis. However, recent laboratory experiments have called into question the robustness of those initial results. In this paper, we offer the first attempt to directly replicate key findings of the original study. Failing to replicate their results, the post-study probability that market performance is better described by rational expectations than the prior information (Walrasian) model is low. Given this result, we introduce a new treatment that implements a market structure consistent with naturally occurring prediction markets, which can be viewed as completing the original experimental design. In this new treatment, we find strong support for the rational expectations model. Thus, while the original paper showed conditions where markets can aggregate information, we attempt to identify sufficient conditions for such aggregation to be robust. |
| Keywords: | Information Aggregation; Efficient Markets; Rational Expectations; Replication |
| JEL: | D4 D8 C9 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:chu:wpaper:20-03&r=all |
| By: | Franz Dietrich (CNRS - Centre National de la Recherche Scientifique, PSE - Paris School of Economics, CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Antonios Staras (Cardiff University); Robert Sugden (UEA - University of East Anglia [Norwich]) |
| Abstract: | Logical models of the mind focus on beliefs, and how one reasons with beliefs. But we also have desires, intentions, preferences, and other attitudes-and arguably we reason with them, particularly when making decisions. To enable a logical analysis of someone's psychology and decision-making, we generalize three classic logical desiderata on beliefs -- consistency, completeness, and implication-closedness -- towards multiple attitudes. The three resulting 'logical' desiderata on our psychology contrast with the classic notion of 'rationality requirements': requirements of having transitive preferences, non-contradictory beliefs, non-acratic intentions, intentions consistent with preferences, and so on. We prove a theorem that connects the logical desiderata to rationality requirements: each of the three logical desiderata (generalized to multiple attitudes) is equivalent to the satisfaction of a certain class of rationality requirements. This result connects logic with choice theory and psychology, and has implications for whether reasoning can make our attitudes consistent, complete, and closed. |
| Date: | 2020–01–08 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:halshs-02431917&r=all |
| By: | Hof, Franz X.; Prettner, Klaus |
| Abstract: | We employ a novel approach for analyzing the effects of relative consumption and relative wealth preferences on both the decentralized and the socially optimal economic growth rates. In the pertinent literature these effects are usually assessed by examining the dependence of the growth rates on the two parameters of the instantaneous utility function that seem to measure the strength of the relative consumption and the relative wealth motive. We go beyond the sole consideration of parameters by revealing the fundamental factors that ultimately determine long-run growth. In doing so we identify widely used types of status preferences in which the traditional approach is prone to erroneous conclusions. For example, in one of these specifications the parameter that seems to determine the strength of the relative consumption motive actually also affects the strength of the relative wealth motive and the elasticity of intertemporal substitution. |
| Keywords: | relative consumption,relative wealth,quest for status,long-run economic growth,social optimality,deep factors |
| JEL: | D31 D62 O10 O30 |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:hohdps:122019&r=all |
| By: | Beckert, Jens; Bronk, Richard |
| Abstract: | Dynamic capitalist economies are characterised by relentless innovation and novelty and hence exhibit an indeterminacy that cannot be reduced to measurable risk. How then do economic actors form expectations and decide how to act despite this uncertainty? This paper focuses on the role played by imaginaries, narratives, and calculative technologies, and argues that the market impact of shared calculation devices, social narratives, and contingent imaginaries underlines the rationale for a new form of 'narrative economics' and a theory of fictional (rather than rational) expectations. When expectations cannot be anchored in objective probability functions, the future belongs to those with the market, political, or rhetorical power to make their models or stories count. The paper also explores the dangers of analytical monocultures and the discourse of best practice in conditions of uncertainty, and considers the link between uncertainty and some aspects of populism. |
| Keywords: | calculation,fictional expectations,future,imaginaries,innovation,narrative economics,uncertainty,fiktionale Erwartungen,Innovation,Kalkulation,narrative Wirtschaftswissenschaften,Ungewissheit,Vorstellungen,Zukunft |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:mpifgd:1910&r=all |