nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2020‒07‒13
twelve papers chosen by

  1. Risk attitudes over small and large stakes recalibrated By Eduardo Zambrano
  2. Relative utility bounds for empirically optimal portfolios By Dmitry B. Rokhlin
  3. On the role of probability weighting on WTP for crop insurance with and without yield skewness By Douadia Bougherara; Laurent Piet
  4. Why Is Risk Aversion Essentially Important for Endogenous Economic Growth? By Harashima, Taiji
  5. Additive-Belief-Based Preferences By David Dillenberger; Collin Raymond
  6. A Systematic Test of the Independence Axiom Near Certainty By Ritesh Jain; Kirby Nielsen
  7. Distilling Large Information Sets to Forecast Commodity Returns: Automatic Variable Selection or HiddenMarkov Models? By Massimo Guidolin; Manuela Pedio
  8. Subjective Information Choice Processes By David Dillenberger; R. Vijay Krishna; Philipp Sadowski
  9. Taxation in Matching Markets By Dupuy, Arnaud; Galichon, Alfred; Jaffe, Sonia; Kominers, Scott Duke
  10. Public Debt Dynamics under Ambiguity by Means of Iterated Function Systems on Density Functions By La Torre, Davide; Marsiglio, Simone; Mendivil, Franklin; Privileggi, Fabio
  11. Semiparametric Estimation of Dynamic Binary Choice Panel Data Models By Fu Ouyang; Thomas Tao Yang
  12. The Equilibrium Existence Duality: Equilibrium with Indivisibilities & Income Effects By Elizabeth Baldwin; Paul Klemperer; Alex Teytelboym; Omer Edhan Ravi Jagadeesan

  1. By: Eduardo Zambrano (Department of Economics, California Polytechnic State University)
    Abstract: In this paper I provide bounds on the marginal rate of substitution between losing $x and winning $y, starting from wealth level $w, for a risk averse individual that rejects a small stake gamble for a range of initial wealth levels. I then prove a theorem that can be used to identify the kinds of large stakes that would be rejected by any such individual. The theorems allow us to understand how much risk aversion is embedded in anyone's rejections of certain small stakes gambles and provide tighter connections between the results in Rabin (2000) and the received theory of decision making under risk.
    Keywords: Expected Utility Theory, Risk Aversion Calibration
    JEL: D81
    Date: 2019
  2. By: Dmitry B. Rokhlin
    Abstract: We consider a single-period portfolio selection problem for an investor, maximizing the expected ratio of the portfolio utility and the utility of a best asset taken in hindsight. The decision rules are based on the history of stock returns with unknown distribution. Assuming that the utility function is Lipschitz or H\"{o}lder continuous (the concavity is not required), we obtain high probability utility bounds under the sole assumption that the returns are independent and identically distributed. These bounds depend only on the utility function, the number of assets and the number of observations. For concave utilities similar bounds are obtained for the portfolios produced by the exponentiated gradient method. Also we use statistical experiments to study risk and generalization properties of empirically optimal portfolios. Herein we consider a model with one risky asset and a dataset, containing the stock prices from NYSE.
    Date: 2020–06
  3. By: Douadia Bougherara (CEE-M - Centre d'Economie de l'Environnement - Montpellier - FRE2010 - INRA - Institut National de la Recherche Agronomique - UM - Université de Montpellier - CNRS - Centre National de la Recherche Scientifique - Montpellier SupAgro - Institut national d’études supérieures agronomiques de Montpellier); Laurent Piet (SMART - Structures et Marché Agricoles, Ressources et Territoires - AGROCAMPUS OUEST - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement)
    Abstract: A growing number of studies in finance and economics seek to explain insurance choices using the assumptions advanced by behavioral economics. One recent example in agricultural economics is the use of cumulative prospect theory (CPT) to explain farmer choices regarding crop insurance coverage levels (Babcock, 2015). We build upon this framework by deriving willingness to pay (WTP) for insurance programs under alternative assumptions, thus extending the model to incorporate farmer decisions regarding whether or not to purchase insurance. Our contribution is twofold. First, we study the sensitivity of farmer WTP for crop insurance to the inclusion of CPT parameters. We find that loss aversion and probability distortion increase WTP for insurance while risk aversion decreases it. Probability distortion in losses plays a particularly important role. Second, we study the impact of yield distribution skewness on farmer WTP assuming CPT preferences. We find that WTP decreases when the distribution of yields moves from negatively- to positively-skewed and that the combined effect of probability weighting in losses and skewness has a large negative impact on farmer WTP for crop insurance.
    Keywords: Crop Insurance,Cumulative Prospect Theory,premium subsidy,skewness
    Date: 2020–06–05
  4. By: Harashima, Taiji
    Abstract: The familiar condition for a balanced growth path indicates that a household’s attitude toward risk plays a significantly important role for endogenous economic growth, but the mechanism behind this importance has not been sufficiently examined. In this paper, I show that in the process of endogenous growth, the decreasing rate of marginal utility is kept constant and the household’s quickness of response to new technologies determines the growth rate. Quickness of response to new technology and degree of risk aversion are quite similar. Given a constant decreasing rate of marginal utility, if on average households in a country are more cautious and respond less quickly to new technologies, firms in that country will invest less in new technologies. As a result, the endogenous economic growth rate of the country will be lower than that of others. If people respond more quickly, the growth rate will be higher.
    Keywords: Decreasing rate of marginal utility; Endogenous economic growth; Risk aversion
    JEL: D81 O40
    Date: 2020–06–10
  5. By: David Dillenberger (University of Pennsylvania); Collin Raymond (Purdue University)
    Abstract: We introduce a new class of preferences — which we call additive-belief-based (ABB) — that captures a general yet tractable approach to belief-based utility, and that encompasses many popular models in the behavioral literature. We show that the general class of ABB preferences and two prominent special cases, which allow utility to depend on each period’s beliefs but not on changes in beliefs across periods, are fully characterized by suitable relaxations of the standard Independence Axiom. We identify the intersection of ABB preferences with the class of recursive preferences and characterize attitudes towards the timing of resolution of uncertainty for ABB preferences. Our approach helps to better understand existing models and leads to new models that can accommodate previously uncaptured behavioral patterns.
    Keywords: Anticipatory utility, Compound lotteries, Preferences over beliefs, Recursive preferences, Resolution of uncertainty
    JEL: D80 D81 D83 D91
    Date: 2019–11–24
  6. By: Ritesh Jain (Institute of Economics, Academia Sinica, Taipei, Taiwan); Kirby Nielsen (Department of Economics, Stanford University)
    Abstract: A large literature has documented violations of expected utility consistent with a preference for certainty (the “certainty effect”). We design a laboratory experiment to investigate the role of the certainty effect in explaining violations of the independence axiom. We use lotteries spanning over the entire probability simplex to detect violations systematically. We find that violations of independence consistent with the reverse certainty effect are much more common than violations consistent with the certainty effect. Results hold as we test robustness along two dimensions: varying the mixing lottery and moving slightly away from certainty.
    Keywords: : independence axiom, expected utility theory, certainty effect, Allais Paradox
    JEL: C79 D82
    Date: 2020–06
  7. By: Massimo Guidolin; Manuela Pedio
    Abstract: We investigate the out-of-sample, recursive predictive accuracy for (fully hedged) commodity future returns of two sets of forecasting models, i.e., hidden Markov chain models in which the coefficients of predictive regressions follow a regime switching process and stepwise variable selection algorithms in which the coefficients of predictors not selected are set to zero. We perform the analysis under four alternative loss functions, i.e., squared and the absolute value, and the realized, portfolio Sharpe ratio and MV utility when the portfolio is built upon optimal weights computed solving a standard MV portfolio problem. We find that neither HMM or stepwise regressions manage to systematically (or even just frequently) outperform a plain vanilla AR benchmark according to RMSFE or MAFE statistical loss functions. However, in particular stepwise variable selection methods create economic value in out-of-sample meanvariance portfolio tests. Because we impose transaction costs not only ex post but also ex ante, so that an investor uses the forecasts of a model only when they increase expected utility, the economic value improvement is maximum when transaction costs are taken into account.
    Keywords: Backward and forward stepwise regressions; hidden Markov models, out-of-sample forecasting; commodity futures returns; mean-variance portfolios.
    Date: 2020
  8. By: David Dillenberger (University of Pennsylvania); R. Vijay Krishna (Florida State University); Philipp Sadowski (Duke University)
    Abstract: We propose a class of dynamic models that capture subjective (and hence unob-servable) constraints on the amount of information a decision maker can acquire, pay attention to, or absorb, via an Information Choice Process (icp). An icp specifies the information that can be acquired about the payo?-relevant state in the current period, and how this choice a?ects what can be learned in the future. In spite of their generality, wherein icps can accommodate any dependence of the information constraint on the history of information choices and state realizations, we show that the constraints imposed by them are identified up to a dynamic extension of Blackwell dominance. All the other parameters of the model are also uniquely identified. Behaviorally, the model is characterized by a novel recursive application of static properties.
    Keywords: Dynamic Preferences, Information Choice Process, Dynamic Blackwell Dominance, Rational Inattention, Subjective Markov Decision Process
    JEL: D80 D81 D90
    Date: 2020–03–06
  9. By: Dupuy, Arnaud (University of Luxembourg); Galichon, Alfred (New York University); Jaffe, Sonia (University of Chicago); Kominers, Scott Duke (Harvard University)
    Abstract: We analyze the effects of taxation in two-sided matching markets where agents have heterogeneous preferences over potential partners. Our model provides a continuous link between models of matching with and without transfers. Taxes generate inefficiency on the allocative margin, by changing who matches with whom. This allocative inefficiency can be non-monotonic, but is weakly increasing in the tax rate under linear taxation if each worker has negative non-pecuniary utility of working. We adapt existing econometric methods for markets without taxes to our setting, and estimate preferences in the college-coach football market. We show through simulations that standard methods inaccurately measure deadweight loss.
    Keywords: matching, taxation
    JEL: C78 D3 H2 J3
    Date: 2020–06
  10. By: La Torre, Davide; Marsiglio, Simone; Mendivil, Franklin; Privileggi, Fabio (University of Turin)
    Abstract: We analyze a purely dynamic model of public debt stabilization under ambiguity. We assume that the debt to GDP ratio is described by a random variable, and thus it can be characterized by investigating the evolution of its density function through iteration function systems on mappings. Ambiguity is associated with parameter uncertainty which requires policymakers to respond to such an additional layer of uncertainty according to their ambiguity attitude. We describe ambiguity attitude through a simple heuristic rule in which policymakers adjust the available vague information (captured by the empirical distribution of the debt ratio) with a measure of their ignorance (captured by the uniform distribution). We show that such a model generates fractal-type objects that can be characterized as fixed-point solutions of iterated function systems on mappings. Ambiguity is a source of unpredictability in the long run outcome since it introduces some singularity features in the steady state distribution of the debt ratio. However, the presence of some ambiguity aversion removes such unpredictability by smoothing our the singularities in the steady state distribution.
    Date: 2020–04
  11. By: Fu Ouyang (School of Economics, University of Queensland); Thomas Tao Yang (Australian National University)
    Abstract: We propose a new approach to the semiparametric analysis of panel data binary choice models with fixed effects and dynamics (lagged dependent variables). The model we consider has the same random utility framework as in Honor´e and Kyriazidou (2000). We demonstrate that, with additional serial dependence conditions on the process of deterministic utility and tail restrictions on the error distribution, the (point) identification of the model can proceed in two steps, and only requires matching the value of an index function of explanatory variables over time, as opposed to that of each explanatory variable. Our identification approach motivates an easily implementable, two-step maximum score (2SMS) procedure – producing estimators whose rates of convergence, in contrast to Honor´e and Kyriazidou’s (2000) methods, are independent of the model dimension. We then derive the asymptotic properties of the 2SMS procedure and propose bootstrap-based distributional approximations for inference. Monte Carlo evidence indicates that our procedure performs adequately in finite samples. We then apply the proposed estimators to study labor market dependence and the effects of health shocks, using data from the Household, Income and Labor Dynamics in Australia (HILDA) survey.
    Keywords: Bundle choices; rank estimation; panel data; bootstrap.
    JEL: C13 C14 C35
    Date: 2020–04–29
  12. By: Elizabeth Baldwin; Paul Klemperer; Alex Teytelboym; Omer Edhan Ravi Jagadeesan
    Abstract: Abstract We show that, with indivisible goods, the existence of competitive equilibrium fundamentally depends on agents’ substitution effects, not their income effects. Our Equilibrium Existence Duality allows us to transport results on the existence of competitive equilibrium from settings with transferable utility to settings with income effects. One consequence is that net substitutability—which is a strictly weaker condition than gross substitutability—is sufficient for the existence of competitive equilibrium. We also extend the “demand types†classification of valuations to settings with income effects and give necessary and sufficient conditions for a pattern of substitution effects to guarantee the existence of competitive equilibrium.
    JEL: C62 D11 D44
    Date: 2020–06–17

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