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on Utility Models and Prospect Theory |
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Issue of 2020‒04‒20
fourteen papers chosen by |
| By: | Pablo Schenone |
| Abstract: | Most decision problems can be understood as a mapping from a preference space into a set of outcomes. When preferences are representable via utility functions, this generates a mapping from a space of utility functions into outcomes. We say a model is continuous in utilities (resp., preferences) if small perturbations of utility functions (resp., preferences) generate small changes in outcomes. While similar, these two concepts are equivalent only when the topology satisfies the following universal property: for each continuous mapping from preferences to outcomes there is a unique mapping from utilities to outcomes that is faithful to the preference map and is continuous. The topologies that satisfy such a universal property are called final topologies. In this paper, we analyze the properties of the final topology for preference sets. This is of practical importance since most of the analysis on continuity is done via utility functions and not the primitive preference space. Our results allow the researcher to extrapolate continuity in utility to continuity in the underlying preferences. |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2004.02357&r=all |
| By: | Dean R. Lillard |
| Abstract: | The development of nicotine replacement therapies and e-cigarettes emphasize and highlight that, in tobacco demand, nicotine is one of, if not, the primary object people want. This chapter presents a simple model of utility maximization that focuses specifically on nicotine as the object of interest. It yields a derived demand for a nicotine delivery technology and predictions researchers can use to account for patterns in consumption over the life-cycle of individuals and the market as a whole. The model is informed by available evidence about the neurological effects of nicotine and differences in the relative efficiency and associated physical costs of nicotine delivery devices, and genetic differences across individuals that partly explains variation in nicotine consumption. The analysis highlights that one of the key theoretical objects of interest is the price per unit of nicotine delivered to the brain. The limited empirical literature on e-cigarettes does not measure that price. All told, economists have much to offer in modeling and empirically studying demand for the new nicotine delivery products. In addition, a range of studies could look back, reconfigure prices and measured consumption, to better explain patterns in historical time-series data on consumption and substitution across different nicotine delivery devices. |
| JEL: | D8 I1 I12 I18 |
| Date: | 2020–03 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:26912&r=all |
| By: | Ivan Paya; David Peel; Konstantinos Georgalos |
| Abstract: | This is the first paper to provide a comprehensive theoretical analysis of the third and fourth order lottery preferences implied by cumulative prospect theory (CPT). We consider the lottery choices from three alternative reference points: the status quo, the expected payout and the MaxMin. We report a large number of new results given the standard assumptions about probability weighting. We demonstrate, for example, the general result that from the status quo reference point there is no third order reflection effect but there is a fourth order reflection effect. When the average payout or the MaxMin is the reference point, we lose generality but can demonstrate that representative individuals with power value functions can make prudent or imprudent, temperate or intemperate choices depending on the precise magnitude of lottery payoffs. In addition to this, we show that these representative CPT individuals can exhibit some surprising combinations of second with third and fourth order risk attitudes. Throughout the paper, we contrast our theoretical predictions with results reported in the literature and we are able to reconcile some conflicting evidence on higher order risk preferences. |
| Keywords: | cumulative prospect theory, decision making under risk, experiments, higher order preferences, reflection effect |
| JEL: | D8 E21 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:lan:wpaper:293574809&r=all |
| By: | Basu, Arnab K. (Cornell University); Dimova, Ralitza (University of Manchester) |
| Abstract: | Using data from the Rural Ethiopian Household Survey, which contains a behavioral module, we explore the link between adult risk and time preferences and the incidence and the intensity of child labor. While as expected child labor at both the extensive and the intensive margin is a result of high time discount rates, the narrative behind the positive relationship between adult risk aversion and child labor is more complex. While child labor is clearly the result of risk aversion, more risk averse parents react to their uncertain environments by combining child labor and work as opposed to substituting schooling for child labor. |
| Keywords: | risk and time preferences, education, child labor, Ethiopia |
| JEL: | C93 J43 O55 |
| Date: | 2020–02 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp13011&r=all |
| By: | Bougherara, Douadia; Friesen, Lana; Nauges, Céline |
| Abstract: | While much literature has focused on preferences regarding risk, preferences over skewness also have significant economic implications. An important and understudied aspect of skewness preferences is how they affect risk taking. In this paper, we design a novel laboratory experiment that elicits certainty equivalents over lotteries where the variance and skewness of the outcomes are orthogonal to each other. This design enables us to cleanly measure both skewness seeking/avoiding and risk taking behavior, and their interaction, without needing to make parametric assumptions. Our experiment includes both left- and right-skewed lotteries. The results reveal that the majority of subjects are skewness avoiding risk takers who correspondingly also take more risk when facing less skewed lotteries. Our second contribution is to link these choices to individual rank-dependent utility preference parameters estimated using a separate lottery choice protocol. Using a latent-class model, we are able to identify two classes of subjects: skewness avoiders with the classic inverse s-shaped probability weighting function and skewness neutral subjects that do not distort probabilities. Our results thus demonstrate the link between probability distortion and skewness seeking/avoidance choices. They also highlight the importance of accounting for individual heterogeneity. |
| Keywords: | Risk; Skewness; Laboratory Experiment; Probability Weighting |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:tse:wpaper:124180&r=all |
| By: | Kops, Christopher; Pasichnichenko, Illia |
| Abstract: | The standard Bayesian model implies that information can never have a negative value. We put this implication to the proof. Our paper provides the first test of the value (positive or negative) of information under uncertainty. We show that the “Bayesian implication” stands in conflict with the information-averse behavior that is revealed in our experiment. This behavior demonstrates that the value of truthful and unambiguous information may indeed be negative. Our findings complement predictions from recent theoretical work in showing that negative value of information correlates with ambiguity aversion. This highlights the importance of counseling for decision-making under uncertainty. |
| Keywords: | value of Information; ambiguity aversion; Ellsberg paradox; Ellsberg urn |
| Date: | 2020–04–17 |
| URL: | http://d.repec.org/n?u=RePEc:awi:wpaper:0682&r=all |
| By: | Ivan Moscati |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:baf:cbafwp:cbafwp19129&r=all |
| By: | Giovanni Dosi; Mauro Napoletano; Andrea Roventini; Joseph E. Stiglitz; Tania Treibich |
| Abstract: | We analyze the individual and macroeconomic impacts of heterogeneous expectations and action rules within an agent-based model populated by heterogeneous, interacting firms. Agents have to cope with a complex evolving economy characterized by deep uncertainty resulting from technical change, imperfect information, coordination hurdles and structural breaks. In these circumstances, we find that neither individual nor macroeconomic dynamics improve when agents replace myopic expectations with less naïve learning rules. Our results suggest that fast and frugal robust heuristics may not be a second-best option but rather “rational” responses in complex and changing macroeconomic environments. |
| JEL: | C63 D8 E32 E6 O4 |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:26922&r=all |
| By: | Tanaka, Yasuhito |
| Abstract: | We show the existence of involuntary unemployment without assuming wage rigidity. We derive involuntary unemployment by considering utility maximization of consumers and profit maximization of firms in an overlapping generations model under monopolistic competition with increasing or constant returns to scale technology and homothetic preferences of consumers. Indivisibility of labor supply may be a ground for the existence of involuntary unemployment. However, we show that there exists involuntary unemployment even when labor supply is divisible. The existence involuntary unemployment in our model is due to that we use an overlapping generations model of consumptions and labor supply. In a two-periods overlapping generations model it is possible that a reduction of the nominal wage rate reduces unemployment. However, if we consider a three-periods overlapping generations model including a childhood period, a reduction of the nominal wage rate does not necessarily reduce unemployment. |
| Keywords: | involuntary unemployment, monopolistic competition, divisible labor supply, three-periods overlapping generations model. |
| JEL: | E12 E24 |
| Date: | 2020–01–31 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:99354&r=all |
| By: | John Armstrong; Cristin Buescu |
| Abstract: | A collectivised fund is a proposed form of pension investment, in which all investors agree that any funds associated with deceased members should be split among survivors. For this to be a viable financial product, it is necessary to know how to manage the fund even when it is heterogeneous: that is when different investors have different preferences, wealth and mortality. There is no obvious way to define a single objective for a heterogeneous fund, so this is not an optimal control problem. In lieu of an objective function, we take an axiomatic approach. Subject to our axioms on the management of the fund, we find an upper bound on the utility that can be achieved for each investor, assuming a complete markets and the absence of systematic longevity risk. We give a strategy for the management of such heterogeneous funds which achieves this bound asymptotically as the number of investors tends to infinity. |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2004.01506&r=all |
| By: | Orland, Andreas; Rostam-Afschar, Davud |
| Abstract: | In the past years, work time in many industries has become increasingly flexible opening up a new channel for intertemporal substitution. To study this, we set up a two-period model with wage uncertainty. This extends the standard saving model by allowing a worker to allocate a fixed time budget between two work-shifts or to save. To test the existence of these channels, we conduct laboratory consumption/saving experiments. A novel feature of our experiments is that we tie them to a real-effort style task. In four treatments, we turn on and off the two channels for consumption smoothing: saving and time allocation. Our four main findings are: (i) subjects exercise more effort under certainty than under risk; (ii) savings are strictly positive for at least 85 percent of subjects (iii) a majority of subjects uses time allocation to smooth consumption; (iv) saving and time shifting are substitutes, though not perfect substitutes. |
| Keywords: | precautionary saving,labor supply,intertemporal substitution,experiment |
| JEL: | D14 E21 J22 C91 D81 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:hohdps:042020&r=all |
| By: | Joseph Kopecky; Alan M. Taylor |
| Abstract: | Population aging has been linked to global declines in interest rates. A similar trend shows that equity risk premia are on the rise. An existing literature can explain part of the decline in the trend in safe rates using demographics, but has no mechanism to speak to trends in relative asset prices. We calibrate a heterogeneous agent life-cycle model with equity markets, showing that this demographic channel can simultaneously account for both the majority of a downward trend in the risk free rate, while also increasing premium attached to risky assets. This is because the life cycle savings dynamics that have been well documented exert less pressure on risky assets as older households shift away from risk. Under reasonable calibrations we find declines in the safe rate that are considerably larger than most existing estimates between the years 1990 and 2017. We are also able to account for most of the rise in the equity risk premium. Projecting forward to 2050 we show that persistent demographic forces will continue push the risk free rate further into negative territory, while the equity risk premium remains elevated. |
| JEL: | E21 E43 G11 J11 |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:26943&r=all |
| By: | Vijay V. Vazirani; Mihalis Yannakakis |
| Abstract: | In 1979, Hylland and Zeckhauser \cite{hylland} gave a simple and general scheme for implementing a one-sided matching market using the power of a pricing mechanism. Their method has nice properties -- it is incentive compatible in the large and produces an allocation that is Pareto optimal -- and hence it provides an attractive, off-the-shelf method for running an application involving such a market. With matching markets becoming ever more prevalant and impactful, it is imperative to finally settle the computational complexity of this scheme. We present the following partial resolution: 1. A combinatorial, strongly polynomial time algorithm for the special case of $0/1$ utilities. 2. An example that has only irrational equilibria, hence proving that this problem is not in PPAD. Furthermore, its equilibria are disconnected, hence showing that the problem does not admit a convex programming formulation. 3. A proof of membership of the problem in the class FIXP. We leave open the (difficult) question of determining if the problem is FIXP-hard. Settling the status of the special case when utilities are in the set $\{0, {\frac 1 2}, 1 \}$ appears to be even more difficult. |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2004.01348&r=all |
| By: | Krüger, Fabian; Pavlova, Lora |
| Abstract: | Several recent surveys ask for a person's subjective probabilities that the in ation rate falls into various outcome ranges. We provide a new measure of the uncertainty implicit in such probabilities. The measure has several advantages over existing methods: It is robust, trivial to implement, requires no functional form assumptions, and is well-defined for all logically possible probabilities. These advantages are particularly relevant when analyzing large scale consumer surveys. We illustrate the new measure using data from the Survey of Consumer Expectations. |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:kitwps:139&r=all |