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on Utility Models and Prospect Theory |
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Issue of 2020‒03‒02
fourteen papers chosen by |
| By: | Jules Sadefo Kamdem (MRE - Montpellier Recherche en Economie - UM - Université de Montpellier, UG - Université de Guyane); David Akame (MRE - Montpellier Recherche en Economie - UM - Université de Montpellier) |
| Abstract: | This paper extends the work of Pindyck by taking into consideration a large class family of different utility functions of economic agents. As in Pindyck, instead of consideringa social utility function that is characterized by constant relative risk aversion (C.R.R.A), we use the expo-power utility function of Saha. In fact, depending on the choice of the expo-power utility function parameters, we cover a diverse range1of utility functions and besides covering the other utility functions that a C.R.R.A omits, Expo-power function permits usto discern if under the other behaviors of economic agents, the willingness to pay remainsmore affected by uncertain outcomes than certain outcomes, when we vary the expectationand standard deviation of the temperature distribution probability. Our paper has maintained the small-tailed gamma distributions of temperature and economic impact of Pindyck, notonly because they hinder infinite future welfare losses (for an exponential utility function), but because it is easy to change some moments of the distribution (jointly or holding the othersfixed) while studying how uncertainty influences the willingness to pay as explained in Pindyck. |
| Keywords: | Willingness to Pay,Climate Change,Expo-Power Utility,I.A.R.A,D.A.R.A,I.R.R.A,IA |
| Date: | 2020–01–24 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-02465195&r=all |
| By: | Victor H. Aguiar; Per Hjertstrand; Roberto Serrano |
| Abstract: | We offer a rationalization of the weak axiom of revealed preference (WARP) and of the weak generalized axiom of revealed preference (WGARP) for both finite and infinite data sets of consumer choice. We call it maximin rationalization, in which each pairwise choice is associated with a local utility function. We develop its associated revealed-preference theory. We show that preference recoverability and welfare analysis à la Varian (1982) may not be informative enough when the weak axiom holds but when consumers are not utility maximizers. In addition, we show that counterfactual analysis may fail with WGARP/WARP. We clarify the reasons for these failures and provide new informative bounds for the consumer’s true preferences, as well as a new way to perform counterfactual analysis. Finally, by adding the Gorman form and quasilinearity restrictions to the “local” utility functions, we obtain new characterizations of the choices of the Shafer (1974) nontransitive consumer and those choices satisfying the law of demand. |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:bro:econwp:2020-16&r=all |
| By: | Yan, Yu; Wang, Yiming |
| Abstract: | As one of the core models of finance, the consumer capital asset pricing model (CCAPM) has produced the puzzle of equity premium. In order to explain this problem and get a more realistic pricing formula, this paper uses constant absolute risk aversion coefficient (Cara) utility function and introduces heterogeneous consumers to improve the original model, and finally gets a more effective form and there is no original puzzle in this form. At the end of the article, the American data are used to verify the results. The regression results support this model very well. |
| Keywords: | CAPM;CARA;puzzle of equity premium |
| JEL: | G00 |
| Date: | 2020–02–05 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:98506&r=all |
| 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: | 2020–01–30 |
| URL: | http://d.repec.org/n?u=RePEc:cir:cirwor:2020s-05&r=all |
| By: | An Chen; Mitja Stadje; Fangyuan Zhang |
| Abstract: | This paper studies a non-concave optimization problem under a Value-at-Risk (VaR) or an Expected Shortfall (ES) constraint. The non-concavity of the problem stems from the non-linear payoff structure of the optimizing investor. We obtain the closed-form optimal wealth with an ES constraint as well as with a VaR constraint respectively, and explicitly calculate the optimal trading strategy for a CRRA (i.e., constant relative risk aversion) utility function. In our non-concave optimization problem, we find that for any VaR-constraint with an arbitrary risk level, there exists an ES-constraint leading to the same investment strategy, assuming that the regulation only protects the debt holders' benefit to a certain level. This differs from the conclusion drawn in Basak and Shapiro (2001) for the concave optimization problem, where VaR and ES lead to different solutions. |
| Date: | 2020–02 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2002.02229&r=all |
| By: | Natesan, Sumeetha R.; Dutta, Goutam |
| Abstract: | The increase in competition among the vehicle insurance sectors has increased the number of policy options available in the market. This study focuses on the development of a utility function for these policies that will aid policy holders and potential investors in comparing them based on various attributes. A comparison of various vehicle insurance policies can help the customers to compare and choose a vehicle insurance that is suitable to them. Although there are several methods for developing a utility function, in this study, we intend to develop a linear utility model for vehicle insurance policies using two approaches: Logarithmic Goal Programming Model (LGPM) and Conjoint Analysis Method (CAM). We propose to compare the similarities and differences between the results obtained from LGPM and CAM approaches, used for developing the utility function for vehicle insurance policies. We also derive a choice probability of the vehicles insurance policies available in market by developing a multinomial logit choice model. We also study the consistency indicators of the respondents. We will provide useful insights for the use both approaches as research tools. |
| Date: | 2020–02–25 |
| URL: | http://d.repec.org/n?u=RePEc:iim:iimawp:14618&r=all |
| By: | Di Bartolomeo, Giovanni; Di Pietro, Marco; Giannini, Bianca |
| Abstract: | In a world where expectations are heterogeneous, what is the design of the optimal policy? Are canonical policies robust when heterogeneous expectations are considered or would they be associated with large welfare losses? We aim to answer these questions in a stylized simple New Keynesian model where agents’beliefs are not homogeneous. Assuming that a fraction of agents can form their expectations by some adaptive or extrapolative schemes, we focus on an optimal monetary policy by second-order approximation of the policy objective from the consumers’utility function. We find that the introduction of bounded rationality in the New Keynesian framework matters. The presence of heterogeneous agents adds a new dimension to the central bank’s optimization problem— consumption inequality. Optimal policies must be designed to stabilize the cross-variability of heterogeneous expectations. In fact, as long as different individual consumption plans depend on different expectation paths, a central bank aiming to reduce consumption inequality should minimize the cross-sectional variability of expectations. Moreover, the traditional trade-off between the price dispersion and aggregate consumption variability is also quantitatively affected by heterogeneity. |
| Keywords: | monetary policy; bounded rationality; heterogeneous expectations |
| JEL: | E52 E58 J51 E24 |
| Date: | 2020–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpm:dynare:054&r=all |
| By: | Drakopoulos, Stavros A. |
| Abstract: | In Keynes’ consumption theory absolute income is the major determinant of consumption, and the marginal propensity to consume determines the magnitudes of fiscal multipliers. Keynes employed a largely psychological analysis of consumption, rejecting the model of utility maximizing consumer. J. Duesenberry extended and improved Keynes’ approach by also emphasizing the role of psychological and social factors on consumption decisions (the relative income hypothesis). Similar conclusions regarding the role of income on consumption, and therefore support for Keynesian policies, are reached by Duesenberry’s analysis. The life-cycle hypothesis by Modigliani and Brumberg (1954), and the permanent income hypothesis by Friedman (1957), emerged as the two main alternatives to Keynes’ and Duesenberry’s approaches. Modern orthodox consumption theories are extensions of these two theories in a rational expectations framework. By employing the concept of forward looking, optimizing agents, current or relative income plays a minimal role in the life-cycle and permanent income hypotheses, and an even lesser role in contemporary orthodox consumption theories. Consequently, fiscal policy has a negligible effect on output and employment. The paper argues that Keynes and Duesenberry’s approaches were marginalized not because of their empirical or theoretical shortcomings, but because of emphasizing the psychological and social influences on consumption patterns, and because of not employing the intertemporal utility maximizing framework. The clear implication of the discussion is that the marginalization of absolute and relative income hypotheses was due to the dominance of a specific methodological framework that did not favour such approaches. |
| Keywords: | Consumption Function; Keynes; Duesenberry; Economic Methodology |
| JEL: | B20 B40 E21 E62 |
| Date: | 2020–02 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:98569&r=all |
| By: | Ankush Agarwal; Christian-Oliver Ewald; Yongjie Wang |
| Abstract: | This work studies a stochastic optimal control problem for a pension scheme which provides an income-drawdown policy to its members after their retirement. To manage the scheme efficiently, the manager and members agree to share the investment risk based on a pre-decided risk-sharing rule. The objective is to maximise both sides' utilities by controlling the manager's investment in risky assets and members' benefit withdrawals. We use stochastic affine class models to describe the force of mortality of the members' population and consider a longevity bond whose coupon payment is linked to a survival index. In our framework, we also investigate the longevity basis risk, which arises when the members' and the longevity bond's reference populations show different mortality behaviours. By applying the dynamic programming principle to solve the corresponding HJB equations, we derive optimal solutions for the single- and sub-population cases. Our numerical results show that by sharing the risk, both manager and members increase their utility. Moreover, even in the presence of longevity basis risk, we demonstrate that the longevity bond acts as an effective hedging instrument. |
| Date: | 2020–02 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2002.05232&r=all |
| By: | Shiba Suzuki (Seikei University); Hiroaki Yamagami (Seikei University) |
| Abstract: | This study explores how investors' optimism about the likelihood of pollution-driven disaster occurrence affects asset prices. Environmental pollution resulting from economic activities raises the probability of disaster occurrence. However, the relationship between economic activities, pollution, and disaster occurrence is difficult to ascertain. Thus, investors make decisions based on subjective expectation; specifically, they subjectively evaluate the probability of disaster occurrence to be lower than its objective probability. As demonstrated in this study, the equity premiums under conditions of objective expectation are significantly higher than those under subjective expectation conditions only if a representative agent has high Intertemporal Elasticity of Substitution (IES). This discrepancy in asset returns is related to the propensity of individuals to discount events occurring in the "distant future" as described in existing literature. |
| Keywords: | Expectations, Disasters, Equity Premium Puzzles, Discount Rate, Climate Change |
| JEL: | G12 Q54 |
| Date: | 2020–02 |
| URL: | http://d.repec.org/n?u=RePEc:fae:wpaper:2020.06&r=all |
| By: | Guilherme Lichand; Anandi Mani |
| Abstract: | Poverty involves both low income levels and high income uncertainty. Do both these dimensions of being poor capture attention in ways that distort decision-making and trap people in poverty? We examine these issues using real-life shocks faced by farmers in Brazil: random payday variation affecting income levels, and rainfall shocks that affect income uncertainty. We find that it is income uncertainty that systematically has adverse cognitive effects; low income levels affect only the poorest households. The net adverse impacts on cognitive function prevail even though both dimensions of poverty reallocate attention to scarce-resource tasks. These results broaden our understanding of the impacts of uncertainty by exploring a psychological channel distinct from risk aversion, and help reconcile apparently contradictory evidence on the cognitive impact of poverty in previous studies. |
| Keywords: | Uncertainty, attention, psychology of poverty, scarcity |
| JEL: | D81 D91 I32 |
| Date: | 2020–02 |
| URL: | http://d.repec.org/n?u=RePEc:zur:econwp:341&r=all |
| By: | David Danz; Lise Vesterlund; Alistair J. Wilson |
| Abstract: | Belief elicitation is central to inference on economic decision making. The recently introduced Binarized Scoring Rule (BSR) is heralded for its robustness to individuals holding risk averse preferences and for its superior performance when eliciting beliefs. Consequently, the BSR has become the state-of-the-art mechanism. We study truth telling under the BSR and examine whether information on the offered incentives improves reports about a known objective prior. We find that transparent information on incentives gives rise to error rates in excess of 40 percent, and that only 15 percent of participants consistently report the truth. False reports are conservative and appear to result from a biased perception of the BSR incentives. While attempts to debias are somewhat successful, the highest degree of truth telling occurs when information on quantitative incentives is withheld. Consistent with incentives driving false reports, we find that slow release of information decreases truth telling. Perversely, our results suggest that information on the BSR incentives substantially distorts reported beliefs. |
| Keywords: | incentive compatibility, belief elicitation, binarized scoring rule, experiments |
| JEL: | C90 D80 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_8048&r=all |
| By: | Harashima, Taiji |
| Abstract: | Recessions are generated by various shocks. In particular, if fundamental shocks change the steady state, severe recessions will be generated. In this paper, I show that when such a shock occurs, it is possible for households to rationally select a Nash equilibrium consisting of a Pareto inefficient transition path to the new steady state in an economy in which households behave according to a procedure that is not based on the expected utilities discounted by the rate of time preference. They select this path because they are non-cooperative and risk averse and want to reach what I call the “maximum degree of comfortability” or MDC. The MDC mechanism behind choosing a Pareto inefficient path is basically the same as that in an economy in which households behave according to the usually assumed procedure based on the rational expectations hypothesis. |
| Keywords: | Economic fluctuation; MDC-based procedure; Pareto inefficiency; Rational expectations hypothesis; Recession |
| JEL: | E00 E10 E32 |
| Date: | 2020–02–02 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:98468&r=all |
| By: | Rohan Kekre (University of Chicago - Booth School of Business); Moritz Lenel (Princeton University - Bendheim Center for Finance) |
| Abstract: | We study the transmission of monetary policy through risk premia in a heterogeneous agent New Keynesian environment. Heterogeneity in households' marginal propensity to take risk (MPR) summarizes differences in portfolio choice on the margin. An unexpected reduction in the nominal interest rate redistributes to households with high MPRs, lowering risk premia and amplifying the stimulus to the real economy. Quantitatively, this mechanism rationalizes the role of news about future excess returns in driving the stock market response to monetary policy shocks. |
| Keywords: | monetary policy, risk premia, heterogeneous agents |
| JEL: | E44 E63 G12 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:bfi:wpaper:2020-02&r=all |