nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2020‒03‒09
seventeen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Categorical Salience Theory By Mark Schneider; Cary Deck; Patrick DeJarnette
  2. A Rationalization of the Weak Axiom of Revealed Preference By Aguiar, Victor H.; Hjertstrand, Per; Serrano, Roberto
  3. Fundamental utilitarianism and intergenerational equity with extinction discounting By Chichilnisky, Graciela; Hammond, Peter J.; Stern, Nicholas
  4. Optimal liquidation trajectories for the Almgren-Chriss model with Levy processes By Arne Lokka; Junwei Xu
  5. Attention Utility: Evidence from Individual Investors By Edika Quispe-Torreblanca; John Gathergood; George Loewenstein; Neil Stewart
  6. Asymptotically Optimal Control of a Centralized Dynamic Matching Market with General Utilities By Jose H. Blanchet; Martin I. Reiman; Viragh Shah; Lawrence M. Wein
  7. Judgementalism about normative decision theory By Thoma, Johanna
  8. An RBC model with Epstein-Zin (non-expected-utility) recursive preferences: lessons from Bulgaria (1999-2018) By Aleksandar Vasilev
  9. Business Cycle Fluctuations in Mirrlees Economies: The Case of i.i.d. Shocks By Marcelo Veracierto
  10. Optimal liquidation for a risk averse investor in a one-sided limit order book driven by a Levy process By Arne Lokka; Junwei Xu
  11. An Empirical Study of the Sentiment Capital Asset Pricing Model By Soroush Ghazi; Mark Schneider
  12. Convex Combinatorial Auction of Pipeline Network Capacities By D\'avid Csercsik
  13. A polynomial algorithm for maxmin and minmax envy-free rent division on a soft budget By Rodrigo A. Velez
  14. Understanding Migration Aversion Using Elicited Counterfactual Choice Probabilities By Gizem Kosar; Tyler Ransom; Wilbert van der Klaauw
  15. Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response? By Giancarlo Corsetti; Luca Dedola; Sylvain Leduc
  16. Are Large Deficits and Debt Dangerous? By Michael J. Boskin
  17. Deriving utility: consumers’ diligence under externalities and technical progress By Malakhov, Sergey

  1. By: Mark Schneider (The University of Alabama); Cary Deck (The University of Alabama; Economic Science Institute, Chapman University); Patrick DeJarnette (Waseda University)
    Abstract: Monetary lotteries are the overwhelmingly predominant tool for understanding decisions under risk. However, many real-world decisions concern multidimensional outcomes involving dierent goods. Recent studies have tested whether people treat multidimensional risky choices in the same manner as unidimensional monetary lotteries and found that choices over consumer goods are less risk-averse and more consistent with expected utility theory than choices over monetary lotteries. While these puzzling results cannot be explained by any standard model of decision making, we demonstrate that these ndings are predicted by a salience-based model of category-dependent preferences that also explains the classic anomalies for choices under risk. Additionally, we experimentally verify a novel prediction of this Categorical Salience Theory. We further demonstrate that our model can explain empirical puzzles in nancial markets, insurance markets, and principal agent settings, including behavior in a new portfolio choice experiment that is unexplained by expected utility theory or prospect theory.
    Keywords: Salience; Categorization; Choice under Risk
    JEL: D90 D91
    Date: 2020
  2. By: Aguiar, Victor H. (Department of Economics); Hjertstrand, Per (Research Institute of Industrial Economics (IFN)); Serrano, Roberto (Department of Economics)
    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.
    Keywords: Consumer choice; Revealed preference; Maximin rationalization; Nonconvex preferences; Reference-dependent utility; Law of demand
    JEL: C60 D10
    Date: 2020–02–26
  3. By: Chichilnisky, Graciela; Hammond, Peter J.; Stern, Nicholas
    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 (Contemporary economic issues. International Economic Association Series. Palgrave Macmillan, London, 1999a; Discounting and Intergenerational Effects, Resources for the Future Press, Washington DC, 1999b) accepted, perhaps reluctantly, what he called Koopmans’ (Econometrica 28(2):287–309, 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.
    JEL: J1
    Date: 2020–01–23
  4. By: Arne Lokka; Junwei Xu
    Abstract: We consider an optimal liquidation problem with infinite horizon in the Almgren-Chriss framework, where the unaffected asset price follows a Levy process. The temporary price impact is described by a general function which satisfies some reasonable conditions. We consider an investor with constant absolute risk aversion, who wants to maximise the expected utility of the cash received from the sale of his assets, and show that this problem can be reduced to a deterministic optimisation problem which we are able to solve explicitly. In order to compare our results with exponential Levy models, which provides a very good statistical fit with observed asset price data for short time horizons, we derive the (linear) Levy process approximation of such models. In particular we derive expressions for the Levy process approximation of the exponential Variance-Gamma Levy process, and study properties of the corresponding optimal liquidation strategy. We then provide a comparison of the liquidation trajectories for reasonable parameters between the Levy process model and the classical Almgren-Chriss model. In particular, we obtain an explicit expression for the connection between the temporary impact function for the Levy model and the temporary impact function for the Brownian motion model (the classical Almgren-Chriss model), for which the optimal liquidation trajectories for the two models coincide.
    Date: 2020–02
  5. By: Edika Quispe-Torreblanca; John Gathergood; George Loewenstein; Neil Stewart
    Abstract: Attention utility is the hedonic pleasure or pain derived purely from paying attention to information. Using data on brokerage account logins by individual investors, we show that individuals devote disproportionate attention to already-known positive information about the performance of individual stocks within their portfolios. This aversion to paying attention to unfavorable information, through its effect on logins, has consequences for trading activity; it reduces trading after recent losses and increases trading after recent gains. Attention utility is distinct from models of belief-based utility and information aversion (in which information not sought is not fully known), and implies that the pleasure and pain of attending to known information may be important for individual behavior.
    Keywords: information utility, attention, login, investor behavior
    JEL: D14
    Date: 2020
  6. By: Jose H. Blanchet; Martin I. Reiman; Viragh Shah; Lawrence M. Wein
    Abstract: We consider a matching market where buyers and sellers arrive according to independent Poisson processes at the same rate and independently abandon the market if not matched after an exponential amount of time with the same mean. In this centralized market, the utility for the system manager from matching any buyer and any seller is a general random variable. We consider a sequence of systems indexed by $n$ where the arrivals in the $n^{\mathrm{th}}$ system are sped up by a factor of $n$. We analyze two families of one-parameter policies: the population threshold policy immediately matches an arriving agent to its best available mate only if the number of mates in the system is above a threshold, and the utility threshold policy matches an arriving agent to its best available mate only if the corresponding utility is above a threshold. Using an asymptotic fluid analysis of the two-dimensional Markov process of buyers and sellers, we show that when the matching utility distribution is light-tailed, % (i.e., the expected value of the maximum of many random variables is a regularly varying function with $\alpha=0$) the population threshold policy with threshold $\frac{n}{\ln n}$ is asymptotically optimal among all policies that make matches only at agent arrival epochs. In the heavy-tailed case% (i.e., $\alpha\in(0,1)$), we characterize the optimal threshold level for both policies. %although they do not attain the performance of our loose upper bound. We also study the utility threshold policy in an unbalanced matching market with heavy-tailed matching utilities, and find that the buyers and sellers have the same asymptotically optimal utility threshold.
    Date: 2020–02
  7. By: Thoma, Johanna
    Abstract: Judgementalism is an interpretation of normative decision theory according to which preferences are all-things-considered judgements of relative desirability, and the only attitudes that rationally constrain choice. The defence of judgementalism we find in Richard Bradley’s Decision Theory with a Human Face (Cambridge University Press, Cambridge, 2017) relies on a kind of internalism about the requirements of rationality, according to which they supervene on an agent’s mental states, and in particular those she can reason from. I argue that even if we grant such internalism, attitudes other than preferences in the judgementalist sense rationally constrain choice. This ultimately supports a different interpretation of preference.
    Keywords: decision theory; preference; rational requirements
    JEL: J1
    Date: 2019–12–11
  8. By: Aleksandar Vasilev (Lincoln International Business School, UK)
    Abstract: We introduce Epstein-Zin (1989, 1991) preferences into a real-business-cycle setup augmented with a detailed government sector. We calibrate the model to Bulgarian data for the period following the introduction of the currency board arrangement (1999- 2018). We investigate the quantitative importance of the presence of Óearly resolution of uncertaintyÓ motive for the propagation of cyclical fluctuations in Bulgaria. Al- lowing for Epstein-Zin preferences improves the model performance against data, and in addition this extended setup dominates the standard RBC model framework, e.g., Vasilev (2009).
    Keywords: Business fluctuations, Epstein-Zin preferences, Bulgaria.
    JEL: E32 E22 E37
    Date: 2020–01
  9. By: Marcelo Veracierto (Federal Reserve Bank; Federal Reserve Bank of Chicago)
    Abstract: I consider a real business cycle model in which agents have private information about the i.i.d. realizations of their value of leisure. For the case of logarithmic preferences I provide an analytical characterization of the solution to the associated mechanism design problem. Moreover, I show a striking irrelevance result: That the stationary behavior of all aggregate variables are exactly the same in the private information economy as in the full information case. Numerical simulations indicate that the irrelevance result approximately holds for more general CRRA preferences.
    Keywords: heterogenous agent; business cycles; private information; social insurance; RBC model; Log consumption; optimal contracts
    JEL: F44 E60 F41
    Date: 2019–12–15
  10. By: Arne Lokka; Junwei Xu
    Abstract: In a general one-sided limit order book where the unaffected price process follows a Levy process, we consider the problem for an investor with constant absolute risk aversion to optimally liquidate a given large position of shares. Since liquidation normally takes place within a short period of time, modelling the risk as a Levy process should provide a realistic model with good statistical fit to observed market data, thus providing a realistic reflection of the investors market risk. We can reduce the optimisation problem to a deterministic two-dimensional singular problem, to which we are able to derive an explicit solution in terms of the model data. In particular we find an expression for the optimal intervention boundary, which completely characterise the optimal liquidation strategy.
    Date: 2020–02
  11. By: Soroush Ghazi (Culverhouse College of Business, University of Alabama); Mark Schneider (Culberhouse College of Business, University of Alabama and Economic Science Institute, Chapman University)
    Abstract: What is market sentiment? This paper takes a new approach to this question and derives a formula for market sentiment as a function of the risk-free rate, the price/dividend ratio, and the conditional stock market volatility. The formula is derived from a representative agent with a prospect theory probability weighting function. We estimate the model and nd that our sentiment measure correlates positively with the leading sentiment indexes. The model matches the equity premium while generating a low and stable risk-free rate with low risk aversion. We also apply the model to explain other anomalies for the aggregate stock market.
    Keywords: Sentiment; Prospect Theory; Equity Premium Puzzle; Pricing Kernel Puzzle; Sentiment Indexes
    Date: 2020
  12. By: D\'avid Csercsik
    Abstract: In this paper we propose a mechanism for the allocation of pipeline capacities, assuming that the participants bidding for capacities do have subjective evaluation of various network routes. The proposed mechanism is based on the concept of bidding for route-quantity pairs. Each participant defines a limited number of routes and places multiple bids, corresponding to various quantities, on each of these routes. The proposed mechanism assigns a convex combination of the submitted bids to each participant, thus its called convex combinatorial auction. The capacity payments in the proposed model are determined according to the Vickrey-Clarke-Groves principle. We compare the efficiency of the proposed algorithm with a simplified model of the method currently used for pipeline capacity allocation in the EU (simultaneous ascending clock auction of pipeline capacities) via simulation, according to various measures, such as resulting utility of players, utilization of network capacities, total income of the auctioneer and fairness.
    Date: 2020–02
  13. By: Rodrigo A. Velez
    Abstract: The current practice of envy-free rent division, lead by the fair allocation website Spliddit, is based on quasi-linear preferences. These preferences rule out agents' well documented financial constraints. To resolve this issue we consider piece-wise linear budget constrained preferences. These preferences admit differences in agents' marginal disutility of paying rent below and above a given reference, i.e., a soft budget. We construct a polynomial algorithm to calculate a maxmin utility envy-free allocation, and other related solutions, in this domain.
    Date: 2020–02
  14. By: Gizem Kosar; Tyler Ransom; Wilbert van der Klaauw
    Abstract: This paper investigates how migration and location choice decisions depend on a large set of location characteristics, with particular focus on measuring the importance and nature of the non-monetary cost of moving. We employ a stated-preference approach to elicit respondents’ choice probabilities for a set of hypothetical choice scenarios, using two waves from the NY Fed’s Survey of Consumer Expectations. Our hypothetical choice methodology elicits choice probabilities from which we recover the distribution of individual-level preferences for location and mobility attributes without concerns about omitted variables and selection biases that hamper analyses based on observed mobility choices alone. We estimate substantial heterogeneity in the willingness-to-pay (WTP) for location characteristics, both across and within demographic groups. Our results also indicate evidence of sorting into current locations based on preferences for these attributes as well as a strong negative association between respondents’ non-monetary moving costs and their moving expectations and actual mobility decisions.
    Keywords: subjective probabilities, stated choice methodology, migration, location choice
    JEL: J61 R23 D84
    Date: 2020
  15. By: Giancarlo Corsetti (Centre for Economic Policy Research; Centre for Macroeconomics (CFM); University of Cambridge); Luca Dedola (Centre for Economic Policy Research; European Central Bank); Sylvain Leduc (Federal Reserve Bank of San Francisco)
    Abstract: How should monetary policy respond to capital inflows that appreciate the currency, widen the current account deficit and cause domestic overheating? Using the workhorse open-macro monetary model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, solve for the optimal targeting rules under cooperation and characterize the constrained-optimal allocation. The answer is sharp: the optimal monetary stance is contractionary if the exchange rate pass-through (ERPT) on import prices is incomplete, expansionary if ERPT is complete – implying that misalignment and exchange rate volatility are higher in economies where incomplete pass through contains the effects of exchange rates on price competitiveness.
    Keywords: Currency misalignments, Trade imbalances, Asset markets and risk sharing, Optimal targeting rules, International policy cooperation, Exchange rate pass-through
    JEL: E44 E52 E61 F41 F42
    Date: 2020–01
  16. By: Michael J. Boskin
    Abstract: The Traditional View (TV) of large deficits and debt is they have large economic costs, save in a recession and early recovery, because they crowd out investment and lower future income, and taken to extremes, can cause inflation and even a financial crisis. The TV has been challenged, most fundamentally in Olivier Blanchard’s 2019 AEA Presidential Address, an elegant extension of Peter Diamond’s OLG model to account for risk in an expected utility framework. He concludes they may have no fiscal cost and increase welfare. I present evidence of looming large deficit and debt/GDP increases and their effects on recovery from recession, interest rates and long-run growth. I discuss several substantive issues with the “no fiscal cost” view that limit its applicability, including accounting neither for the effect of increasing debt on interest rates and growth nor the pre-existing primary deficit, debt and their projected evolution; disputable readings of the data; strong assumptions and parameter values driving the results; and a political economy of deficits and debt likely to lead to even larger debt ratios. Acknowledging uncertainties, the evidence still suggests that large increases in the debt ratio could lead to much higher taxes, lower future incomes and intergenerational inequity.
    JEL: E62 H6 H62 H63 H68
    Date: 2020–02
  17. By: Malakhov, Sergey
    Abstract: If we present sales items or trade units, cars and apartments, in the units of consumption, miles and nights, like it takes place in the sharing&rental economy, we can get the model of the optimal consumption-leisure choice, where the efforts on pre-purchase search and after-purchase care produce non-monetary costs before the use of a trade unit. The paper argues that the productivity of these efforts differs from the efficiency of consumers’ efforts on the workplace. The consumer searches diligently the quantity to be purchased, he spends money earned by his labor or high-productive industry on the purchase and, following his willingness to take care of the purchased item, he takes low-productive diligent efforts in order to finally enjoy it. While the purchase price of the trade unit is equal to consumer’s willingness to pay, the total costs of his industry and diligence become equal to his willingness to accept or to sell the trade unit, the car and the apartment, where his marginal and average costs become equal to the equilibrium price of the unit of consumption, a mile or a night, and total costs become equal to the equilibrium price of the trade unit. The consumers’ productivity function really gets the S-shape, which slows the growth of monetary costs and accelerates the growth of non-monetary costs. While the consumers’ diligence derives the utility from the trade item at the equilibrium level, it enlarges also the spectrum of solutions for the Coase theorem, because the consumers’ diligence copies also with externalities. The trade-off between quantity of consumption units to be purchased and non-monetary efforts for its’ efficient use appears. The assets are redistributed for its more efficient use, from slight to great diligence, or from low to high willingness to take care of the trade unit just in accordance with the Black’s Law Encyclopedia where the great or high diligence is defined as the diligence that a very prudent person exercises in handling his or her own property like that at issue. The model demonstrates that the labor augmenting technical progress decreases the marginal monetary costs of consumers’ industry and increases non-monetary costs of consumers’ diligence at the equilibrium level that can be explained by the loss in the quality of trade units, cars and apartments. The outcome of the service augmenting technical progress is ambiguous. While it raises the equilibrium price, the consumption falls. But the fall in consumption reduces consumers’ diligence and results in the development of the sharing&rental economy. However, if the production and services are gross complements, the consumption growths and Veblen effect is to be expected where consumption becomes “bad” with respect to leisure and the consumers’ diligence becomes excessive.
    Keywords: search, diligence, willingness to take care, Coase theorem, externalities, technical progress
    JEL: D11 D83
    Date: 2020

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