nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2020‒02‒10
twenty-one papers chosen by

  1. Reference Dependence in Intertemporal Preference By Zhihua Li; Songfa Zhong
  2. Student Performance and Loss Aversion By Heiko Karle; Dirk Engelmann; Martin Peitz
  3. Fast then slow: A choice process explanation for the attraction effect By Alexia Gaudeul; Paolo Crosetto
  4. The Rational Group By Franz Dietrich
  5. A Neural-embedded Choice Model: TasteNet-MNL Modeling Taste Heterogeneity with Flexibility and Interpretability By Yafei Han; Christopher Zegras; Francisco Camara Pereira; Moshe Ben-Akiva
  6. Analytic Valuation of GMDB Options with Utility Based Asset Allocation By Ulm, Eric
  7. Long Term Care Insurance with State-Dependent Preferences By Philippe De Donder; Marie-Louise Leroux
  8. The multilinear model in multicriteria decision making: The case of 2-additive capacities and contributions to parameter identification By Guilherme Dean Pelegrina; Leonardo Tomazeli Duarte; Michel Grabisch; João Marcos Travassos Romano
  9. Markov risk mappings and risk-averse optimal stopping under ambiguity By Randall Martyr; John Moriarty
  10. Implied Volatility Duration: A measure for the timing of uncertainty resolution By Schlag, Christian; Thimme, Julian; Weber, Rüdiger
  11. Segregation with Social Linkages: Evaluating Schelling's Model with Networked Individuals By Roy Cerqueti; Luca De Benedictis; Valerio Leone Sciabolazza
  12. Rational Belief Bubbles By H. Sohn; Didier Sornette
  13. Choosing the Right Return Distribution and the Excess Volatility Puzzle By Abootaleb Shirvani; Frank J. Fabozzi
  14. Strategic information transmission with sender's approval By Françoise Forges; Jérôme Renault
  15. Does my model predict a forward guidance puzzle? By Gibbs, Christopher G.; McClung, Nigel
  16. Relative consumption, relative wealth, and long-run growth: When and why is the standard analysis prone to erroneous conclusions? By Hof, Franz X.; Prettner, Klaus
  18. Léon Walras and Alfred Marshall : microeconomic rational choice or human and social nature? By Richard Arena; Katia Caldari
  19. Associative Memory and Belief Formation By Benjamin Enke; Frederik Schwerter; Florian Zimmermann
  20. Cómo resolver un modelo de expectativas racionales By Mario García-Molina; Iván Leonardo Urrea
  21. How Puzzling Is the Forward Premium Puzzle? A Meta-Analysis By Zigraiova, Diana; Havranek, Tomas; Novak, Jiri

  1. By: Zhihua Li (University of Birmingham); Songfa Zhong (National University of Singapore)
    Abstract: This paper examines the role of reference dependence in the elicitation of time preference. The dynamic feature of intertemporal choices offers multiple channels through which the reference effect can occur. Naturally, in evaluating future consumption, one’s current consumption serves as a reference point, and this type of reference point is endogenously determined. Yet potentially exogenous factors are present in the choice environment that also influence the decision maker’s revealed preferences. We performed an experiment that allowed us to examine both the endogenous and exogenous reference effects on the revealed tine preferences. Our design also enabled us to separately estimate the discount factor jointly with the utility curvature. The observed behavioral patterns show that the estimated discount factors were biased by reference endogenous and exogenous points. We also propose a mixture model to account for the reference-dependent effects. We demonstrate that after removing the reference effects and also accounting for the preferences toward money via the utility curvature, the elicited discount factor becomes more patient. We further discuss the implications of the reference-dependent effect on recent observations of elicited intertemporal preferences, including underestimation of the discount factor and the issue of subadditivity.
    Keywords: time preference, reference dependence, prospect theory, experiment
    Date: 2020–02
  2. By: Heiko Karle; Dirk Engelmann; Martin Peitz
    Abstract: In this paper, we match data on student performance in a multiple-choice exam with data on student risk preferences that are extracted from a classroom experiment. We find that more-loss-averse students leave more questions unanswered and perform worse in the multiple-choice exam when giving an incorrect answer is penalized compared to not answering. We provide evidence that loss aversion parameters extracted from lottery choices in a controlled experiment have predictive power in a field environment of decision making under uncertainty. Furthermore, the degree of loss aversion appears to be persistent over time, as the experiment was conducted three months prior to the exam. We also find important differences across genders; they are partly explained by differences in loss aversion.
    Keywords: loss aversion, decision making under uncertainty, multiple choice
    JEL: C91 D01 D11 D83
    Date: 2020–01
  3. By: Alexia Gaudeul (Georg-August-University [Göttingen]); Paolo Crosetto (GAEL - Laboratoire d'Economie Appliquée de Grenoble - Grenoble INP - Institut polytechnique de Grenoble - Grenoble Institute of Technology - INRA - Institut National de la Recherche Agronomique - CNRS - Centre National de la Recherche Scientifique - UGA - Université Grenoble Alpes)
    Abstract: In this paper we provide choice-process experimental evidence that the attraction effect is a short-term phenomenon, that disappears when individuals are given time and incentives to revise their choices.The attraction (or decoy) effect is the most prominent example of context effects, and it appears when adding a dominated option to a choice set increases the choice share of the now dominant option at the expense of other options. While widely replicated, the attraction effect is usually tested in hypothetical or payoff-irrelevant situations and without following the choice process. We run a laboratory experiment where we incentivize choice, vary the difference in utility between options and track which option participants consider best over time. We find that the effect is a transitory phenomenon that emerges only in the early stages of the choice process to later disappear. Participants are fast then slow: they first choose the dominant option to avoid the dominated decoy and then progressively revise their choices until choice shares come to correspond to price differences only. We expand our analysis by considering differences in utility among options and differences in the presentation of options (numerical or graphical). We also consider differences in the choice processes followed by individuals (intuitive vs. deliberative). This allows us to ascribe more precisely the role of fast and slow cognitive process in the emergence and disappearance of the attraction effect.
    Keywords: asymmetric dominance,attraction effect,induced preferences,choice process,time constraint,rationality,context effects,JEL codes : C91,D12,D83
    Date: 2019–12–09
  4. 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)
    Abstract: Can a group be a standard rational agent? This would require the group to hold aggregate preferences which maximise expected utility and change only by Bayesian updating. Group rationality is possible, but the only preference aggregation rules which support it (and are minimally Paretian and continuous) are the linear-geometric rules, which combine individual tastes linearly and individual beliefs geometrically.
    Date: 2020–01–08
  5. By: Yafei Han; Christopher Zegras; Francisco Camara Pereira; Moshe Ben-Akiva
    Abstract: Discrete choice models (DCMs) and neural networks (NNs) can complement each other. We propose a neural network embedded choice model - TasteNet-MNL, to improve the flexibility in modeling taste heterogeneity while keeping model interpretability. The hybrid model consists of a TasteNet module: a feed-forward neural network that learns taste parameters as flexible functions of individual characteristics; and a choice module: a multinomial logit model (MNL) with manually specified utility. TasteNet and MNL are fully integrated and jointly estimated. By embedding a neural network into a DCM, we exploit a neural network's function approximation capacity to reduce specification bias. Through special structure and parameter constraints, we incorporate expert knowledge to regularize the neural network and maintain interpretability. On synthetic data, we show that TasteNet-MNL can recover the underlying non-linear utility function, and provide predictions and interpretations as accurate as the true model; while examples of logit or random coefficient logit models with misspecified utility functions result in large parameter bias and low predictability. In the case study of Swissmetro mode choice, TasteNet-MNL outperforms benchmarking MNLs' predictability; and discovers a wider spectrum of taste variations within the population, and higher values of time on average. This study takes an initial step towards developing a framework to combine theory-based and data-driven approaches for discrete choice modeling.
    Date: 2020–02
  6. By: Ulm, Eric
    Abstract: A number of analytic solutions have been found for Variable Annuity Guaranteed Minimum Death Benefit (GMDB) option values under a variety of mortality laws. To date, the solutions are for Risk-Neutral valuation only. Where policyholder decisions are allowed, it is assumed that they act to maximize the risk-neutral value of the GMDB. We examine situations where the asset allocation decisions are made to maximize expected utility rather than option value. We find analytic solutions for both return of premium and ratchet options at small values of bequest motive for a number of mortality laws.
    Keywords: Guaranteed Minimum Death Benefit, Mortality laws, GMDB,
    Date: 2020
  7. By: Philippe De Donder; Marie-Louise Leroux
    Abstract: We study the demand for actuarially fair Long Term Care (LTC hereafter) insurance in a setting where autonomous agents only care for daily life consumption while dependent agents also care for LTC expenditures. We assume that dependency decreases the marginal utility of daily life consumption. We first obtain that some agents optimally choose not to insure themselves, while no agent wishes to buy complete insurance. We then show that the comparison of marginal utility of income (as opposed to consumption) across health states depends on (i) whether agents do buy LTC insurance at equilibrium or not, (ii) the comparison of the degree of risk aversion for consumption and for LTC expenditures, and (iii) the income level of agents. Our results then offer testable implications that can explain (i) why few people buy Long Term Care insurance and (ii) the discrepancies between various empirical works when measuring the extent of state-dependent preferences for LTC.
    Keywords: long term care insurance puzzle, actuarially fair insurance, risk aversion
    JEL: D11 I13
    Date: 2019
  8. By: Guilherme Dean Pelegrina (DSPCom - Laboratory of Signal Processing for Communications - UNICAMP - University of Campinas [Campinas]); Leonardo Tomazeli Duarte; Michel Grabisch (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); João Marcos Travassos Romano (UnB - University of Brasilia [Brazil])
    Abstract: In several multicriteria decision making problems, it is important to consider interactions among criteria in order to satisfy the preference relations provided by the decision maker. This can be achieved by using aggregation functions based on fuzzy measures, such as the Choquet integral and the multilinear model. Although the Choquet integral has been studied in a large number of works, one does not find the same literature with respect to the multilinear model. In this context, the contribution of this work is twofold. We first provide a formulation of the multilinear model by means of a 2-additive capacity. A second contribution lies in the problem of capacity identification. We consider a supervised approach and apply optimization models with and without regularization terms. Results obtained in numerical experiments with both synthetic and real data attest the performance of the considered approaches.
    Keywords: multiple criteria analysis,multi-attribute utility theory,multilinear model,2-additive capacity,capacity identification
    Date: 2019–10
  9. By: Randall Martyr; John Moriarty
    Abstract: We aim to analyse a Markovian discrete-time optimal stopping problem for a risk-averse decision maker under model ambiguity. In contrast to the analytic approach based on transition risk mappings, a probabilistic setting is introduced based on novel concepts of regular conditional risk mapping and Markov update rule. To accommodate model ambiguity we introduce appropriate notions of history-consistent updating and of transition consistency for risk mappings on nested probability spaces.
    Date: 2020–01
  10. By: Schlag, Christian; Thimme, Julian; Weber, Rüdiger
    Abstract: We introduce Implied Volatility Duration (IVD) as a new measure for the timing of uncertainty resolution, with a high IVD corresponding to late resolution. Portfolio sorts on a large cross-section of stocks indicate that investors demand on average more than five percent return per year as a compensation for a late resolution of uncertainty. In a general equilibrium model, we show that 'late' stocks can only have higher expected returns than 'early' stocks, if the investor exhibits a preference for early resolution of uncertainty. Our empirical analysis thus provides a purely market-based assessment of the timing preferences of the marginal investor.
    Keywords: preference for early resolution of uncertainty,implied volatility,cross-sectionof expected stock returns,asset pricing
    JEL: G12 E44 D81
    Date: 2020
  11. By: Roy Cerqueti; Luca De Benedictis; Valerio Leone Sciabolazza
    Abstract: This paper generalizes the original Schelling (1969, 1971a,b, 2006) model of racial and residential segregation to a context of variable externalities due to social linkages. In a setting in which individuals' utility function is a convex combination of a heuristic function a la Schelling, of the distance to friends, and of the cost of moving, the prediction of the original model gets attenuated: the segregation equilibria are not the unique solutions. While the cost of distance has a monotonic pro-status-quo effect, equivalent to that of models of migration and gravity models, if friends and neighbours are formed following independent processes the location of friends in space generates an externality that reinforces the initial configuration if the distance to friends is minimal, and if the degree of each agent is high. The effect on segregation equilibria crucially depends on the role played by network externalities.
    Date: 2020–01
  12. By: H. Sohn (ETH Zürich); Didier Sornette (ETH Zürich - Department of Management, Technology, and Economics (D-MTEC); Swiss Finance Institute)
    Abstract: We propose an extension of the class of rational expectations bubbles (REBs) to the more general rational beliefs setting of \cite{Kurz:1994,Kurz:1994a}. In a potentially non-stationary but stationarizable environment, among an heterogenous population of agents, it is possible to hold more than one ``rational'' expectation. When rational but diverse beliefs converge (``correlated beliefs''), they do not cancel each other out in aggregate anymore. This can make them an object of rational speculation. Accounting for the fact that market efficiency has an intrinsic time dimension, we show that diverse but correlated beliefs can thus account for speculative bubbles, without the need for irrational agents or limits to arbitrage. Many of the shortcomings of REBs that make rational bubbles implausible can be overcome once we relax the ergodicity requirement. In particular, we argue that the hitherto unexplained ``bubble component'' of REBs corresponds to an extension of the state space in \citet{Kurz:2011}.
    Keywords: Asset pricing, Bubbles, Ecient markets, Rational expectations, Rational Beliefs, Aggregation, Heterogeneous expectations, Correlated beliefs
    JEL: B20 D53 D58 D81 D83 D84 D85 E13 G00
    Date: 2020–02
  13. By: Abootaleb Shirvani; Frank J. Fabozzi
    Abstract: Proponents of behavioral finance have identified several "puzzles" in the market that are inconsistent with rational finance theory. One such puzzle is the "excess volatility puzzle". Changes in equity prices are too large given changes in the fundamentals that are expected to change equity prices. In this paper, we offer a resolution to the excess volatility puzzle within the context of rational finance. We empirically show that market inefficiency attributable to the volatility of excess return across time is caused by fitting an improper distribution to the historical returns. Our results indicate that the variation of gross excess returns is attributable to poorly fitting the tail of the return distribution and that the puzzle disappears by employing a more appropriate distribution for the return data. The new distribution that we introduce in this paper that better fits the historical return distribution of stocks explains the excess volatility in the market and thereby explains the volatility puzzle. Failing to estimate the historical returns using the proper distribution is only one possible explanation for the existence of the volatility puzzle. However, it offers statistical models within the rational finance framework which can be used without relying on behavioral finance assumptions when searching for an explanation for the volatility puzzle.
    Date: 2020–01
  14. By: Françoise Forges (LEDa - Laboratoire d'Economie de Dauphine - IRD - Institut de Recherche pour le Développement - Université Paris-Dauphine - CNRS - Centre National de la Recherche Scientifique, Université Paris-Dauphine, PSL Research University); Jérôme Renault (TSE - Toulouse School of Economics - UT1 - Université Toulouse 1 Capitole - INRA - Institut National de la Recherche Agronomique - EHESS - École des hautes études en sciences sociales - CNRS - Centre National de la Recherche Scientifique, UT1 - Université Toulouse 1 Capitole)
    Abstract: We consider a sender-receiver game with an outside option for the sender. After the cheap talk phase, the receiver makes a proposal to the sender, which the latter can reject. We study situations in which the sender's approval is crucial to the receiver. We show that a partitional, (perfect Bayesian Nash) equilibrium exists if the sender has only two types or if the receiver's preferences over decisions do not depend on the type of the sender as long as the latter participates. The result does not extend: we construct a counter-example (with three types for the sender and type-dependent affine utility functions) in which there is no mixed equilibrium. In the three type case, we provide a full characterization of (possibly mediated) equilibria.
    Date: 2020–01–15
  15. By: Gibbs, Christopher G.; McClung, Nigel
    Abstract: We provide suffcient conditions for when a rational expectations structural model predicts bounded responses of endogenous variables to forward guidance announcements. The conditions coincide with a special case of the well-known (E)xpectation-stability conditions that govern when agents can learn a Rational Expectations Equilibrium. Importantly, we show that the conditions are distinct from the determinacy conditions. We show how the conditions are useful for diagnosing the features of a model that contribute to the Forward Guidance Puzzle and reveal how to construct well-behaved forward guidance predictions in standard medium-scale DSGE models.
    JEL: E31 E32 E52 D84 D83
    Date: 2019–09–10
  16. 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 economicgrowth,social optimality,deep factors
    JEL: D31 D62 O10 O30
    Date: 2020
  17. By: Akshay Bhat
    Abstract: This conceptualessay is to introduce management scholars to the topics of Bounded Rationality, as propounded by Simon (1957) with the initial emphasis of the topic being given to Motivation, in addition to Coordination the other central problem to any Economic Organization and Management. Often these terms are used in scholarly articles but there are subtle differences between the economic and behavioural literature parlances, definition and understanding. These definitions as described in economics with their understanding are very important to understand contracts, the nature of contracts and underlying assumptions made. Here, influential articles from prominent economics’ articleare gleaned; the terms’ rationale and understanding and important aspects are documented to serve as a primer for scholars.The article further elucidates the importance and flaws of Contracts: which are prima facie agreements made by two or more people which are voluntary in nature and accepted by both the parties entering into a contract when they both see their advantage, which on further decomposing will be seen to be mutually beneficial as well, however, under important caveats. Key Words:Bounded Rationality, Private Information, Motivation, Coordination, Contracts, Obligations, Adverse Selection, Trust, Commitment, Hold-up Policy
    Date: 2019–12
  18. By: Richard Arena (GREDEG - Groupe de Recherche en Droit, Economie et Gestion - UNS - Université Nice Sophia Antipolis - UCA - Université Côte d'Azur - CNRS - Centre National de la Recherche Scientifique); Katia Caldari
    Date: 2019–12–09
  19. By: Benjamin Enke; Frederik Schwerter; Florian Zimmermann
    Abstract: Information is often embedded in memorable contexts, which may cue the asymmetric recall of similar past news through associative memory. We design a theorydriven experiment, in which participants observe signals about hypothetical companies. Here, identical signal realizations are communicated with identical contexts: stories and images. Because participants asymmetrically remember those past signals that get cued by the current context, beliefs systematically overreact. This overreaction depends in predictable ways on the signal history; the correlation between signals and contexts; and the scope for forgetting and associative memory. We quantify these results by structurally estimating a model of associative recall.
    Keywords: Beliefs, expectations, memory, bounded rationality
    JEL: D01
    Date: 2020–01
  20. By: Mario García-Molina; Iván Leonardo Urrea
    Abstract: Se presentan los modelos de expectativas racionales y cómo resolverlos mediante el método de coeficientes indeterminados. El nivel de complejidad es el de un curso de macroeconomía intermedia. *** The paper presents the basics of rational expectations models and how to solve them by the method of indeterminate coefficients. The presentation is appropriate for an intermediate macroeconomics course.
    Keywords: expectativas racionales, coeficientes indeterminados, macroeconomía
    JEL: A22 A23 E13 E61
    Date: 2020–01–29
  21. By: Zigraiova, Diana; Havranek, Tomas; Novak, Jiri
    Abstract: A key theoretical prediction in financial economics is that under risk neutrality and rational expectations a currency's forward rates should form unbiased predictors of future spot rates. Yet scores of empirical studies report negative slope coefficients from regressions of spot rates on forward rates, which is inconsistent with the forward rate unbiasedness hypothesis. We collect 3,643 estimates from 91 research articles and using recently developed techniques investigate the effect of publication and misspecification biases on the reported results. Correcting for these biases we estimate the slope coefficients of 0.31 and 0.98 for developed and emerging currencies respectively, which implies that empirical evidence is in line with the theoretical prediction for emerging economies and less puzzling than commonly thought for developed economies. Our results also suggest that the coefficients are systematically influenced by the choice of data, numeraire currencies, and estimation methods.
    Keywords: Forward rate bias,uncovered interest parity,meta-analysis,publication bias
    JEL: C83 F31
    Date: 2020

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