nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2020‒09‒21
sixteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Random Non-Expected Utility: Non-Uniqueness By Yi-Hsuan Lin
  2. Diminishing marginal utility and the teaching of economics: A note By Todorova, Tamara
  3. Optimal Stopping in a Dynamic Salience Model By Markus Dertwinkel-Kalt; Jonas Frey; Mats Köster
  4. Intertemporal Choice Experiments and Large-Stakes Behavior By Aycinena, D; Blazsek, S; Rentschler, L; Sprenger, C
  5. Preference Robust Optimization for Quasi-concave Choice Functions By Jian Wu; William B. Haskell; Wenjie Huang; Huifu Xu
  6. Multi-utility representations of incomplete preferences induced by set-valued risk measures By Cosimo Munari
  7. Identification and Inference in First-Price Auctions with Risk Averse Bidders and Selective Entry By Xiaohong Chen; Matthew Gentry; Tong Li; Jingfeng Lu
  8. COVID-19 Pandemic and Economic Scenarios For Ontario By Miguel Casares; Paul Gomme; Hashmat Khan
  9. Characterizing Pareto Optima: Sequential Utilitarian Welfare Maximization By Yeon-Koo Che; Jinwoo Kim; Fuhito Kojima; Christopher Thomas Ryan
  10. Infinite horizon utility maximisation from inter-temporal wealth By Michael Monoyios
  11. Counterfactual and Welfare Analysis with an Approximate Model By Roy Allen; John Rehbeck
  12. Investing with Cryptocurrencies -- evaluating their potential for portfolio allocation strategies By Alla Petukhina; Simon Trimborn; Wolfgang Karl H\"ardle; Hermann Elendner
  13. On The Value of Alert Systems and Gentle Rule Enforcement in Addressing Pandemics By Roth, Yefim; Plonsky, Ori; Shalev, Edith; Erev, Ido
  14. Constrained Trading Networks By Can Kizilkale; Rakesh Vohra
  15. Involuntary unemployment under monopolistic competition and fiscal policy for full-employment By Tanaka, Yasuhito
  16. Financial Literacy, Risk and Time Preferences - Results from a Randomized Educational Intervention By Matthias Sutter; Michael Weyland; Anna Untertrifaller; Manuel Froitzheim

  1. By: Yi-Hsuan Lin
    Abstract: In random expected utility (Gul and Pesendorfer, 2006), the distribution of preferences is uniquely recoverable from random choice. This paper shows through two examples that such uniqueness fails in general if risk preferences are random but do not conform to expected utility theory. In the first, non-uniqueness obtains even if all preferences are confined to the betweenness class (Dekel, 1986) and are suitably monotone. The second example illustrates random choice behavior consistent with random expected utility that is also consistent with random non-expected utility. On the other hand, we find that if risk preferences conform to weighted utility theory (Chew, 1983) and are monotone in first-order stochastic dominance, random choice again uniquely identifies the distribution of preferences. Finally, we argue that, depending on the domain of risk preferences, uniqueness may be restored if joint distributions of choice across a limited number of feasible sets are available.
    Date: 2020–09
  2. By: Todorova, Tamara
    Abstract: This paper discusses how utility can be taught in undergraduate courses in microeconomics so that to illustrate total and marginal utility, the law of diminishing marginal utility, and consumer rationality. Diminishing marginal utility is essential in describing rational consumer behavior, overconsumption, and oversaturation to students of economics. We demonstrate a quadratic and a logarithmic total utility with the subsequent forms and shapes of marginal utility. From what it seems there is no contradiction between diminishing marginal utility in the univariate context of consuming one good and the indifference curve as the multivariate case of two goods consumed.
    Keywords: total utility,marginal utility,indifference curve
    JEL: B13 B41 D01 D11
    Date: 2020
  3. By: Markus Dertwinkel-Kalt; Jonas Frey; Mats Köster
    Abstract: While many puzzles in static choices under risk can be explained by a preference for positive and an aversion toward negative skewness, little is known about the implications of such skewness preferences for decision making in dynamic problems. Indeed, skewness preferences might play an even bigger role in dynamic environments because, even if the underlying stochastic process is symmetric, the agent can endogenously create a skewed distribution of returns through the choice of her stopping strategy. Guided by salience theory, we theoretically and experimentally analyze the implications of skewness preferences for optimal stopping problems. We find strong support for all salience-based predictions in a laboratory experiment, and we verify that salience theory coherently explains skewness preferences revealed in static and dynamic decisions. Based on these findings we conclude that the static salience model—unlike (static) cumulative prospect theory—can be reasonably applied to dynamic decision problems. Our results have important implications for common optimal stopping problems such as when to sell an asset, when to stop gambling, when to enter the job market or to retire, and when to stop searching for a house or a spouse.
    Keywords: salience theory, prospect theory, skewness preferences, behavioural stopping
    JEL: D01 D81 D90
    Date: 2020
  4. By: Aycinena, D; Blazsek, S; Rentschler, L; Sprenger, C
    Abstract: Intertemporal choice experiments are frequently implemented to make inference about time preferences, yet little is known about the predictive power of resulting measures. This project links standard experimental choices to a decision on the desire to smooth a large-stakes payment — around 10% of annual income — through time. In a sample of around 400 Guatemalan Conditional Cash Transfer recipients, we find that preferences over large-stakes payment plans are closely predicted by experimental measures of patience and diminishing marginal utility. These represent the first findings in the literature on the predictive content of experimentally elicited intertemporal preferences for large-stakes decisions.
    Keywords: Structural estimation, Out-of-sample prediction, Discounting, Convex Time Budget
    JEL: D1 D3 D90
    Date: 2020–08–25
  5. By: Jian Wu; William B. Haskell; Wenjie Huang; Huifu Xu
    Abstract: In behavioural economics, a decision maker's preferences are expressed by choice functions. Preference robust optimization(PRO) is concerned with problems where the decision maker's preferences are ambiguous, and the optimal decision is based on a robust choice function with respect to a preference ambiguity set. In this paper, we propose a PRO model to support choice functions that are: (i) monotonic (prefer more to less), (ii) quasi-concave (prefer diversification), and (iii) multi-attribute (have multiple objectives/criteria). As our main result, we show that the robust choice function can be constructed efficiently by solving a sequence of linear programming problems. Then, the robust choice function can be optimized efficiently by solving a sequence of convex optimization problems. Our numerical experiments for the portfolio optimization and capital allocation problems show that our method is practical and scalable.
    Date: 2020–08
  6. By: Cosimo Munari
    Abstract: We establish a variety of numerical representations of preference relations induced by set-valued risk measures. Because of the general incompleteness of such preferences, we have to deal with multi-utility representations. We look for representations that are both parsimonious (the family of representing functionals is indexed by a tractable set of parameters) and well behaved (the representing functionals satisfy nice regularity properties with respect to the structure of the underlying space of alternatives). The key to our results is a general dual representation of set-valued risk measures that unifies the existing dual representations in the literature and highlights their link with duality results for scalar risk measures.
    Date: 2020–09
  7. By: Xiaohong Chen (Cowles Foundation, Yale University); Matthew Gentry; Tong Li; Jingfeng Lu
    Abstract: We study identification and inference in first-price auctions with risk averse bidders and selective entry, building on a flexible entry and bidding framework we call the Affiliated Signal with Risk Aversion (AS-RA) model. Assuming that the econometrician observes either exogenous variation in the number of potential bidders (N) or a continuous instrument (z) shifting opportunity costs of entry, we provide a sharp characterization of the nonparametric restrictions implied by equilibrium bidding. Given variation in either competition or costs, this characterization implies that risk neutrality is nonparametrically testable in the sense that if bidders are strictly risk averse, then no risk neutral model can rationalize the data. In addition, if both instruments (discrete N and continuous z) are available, then the model primitives are nonparametrically point identified. We then explore inference based on these identification results, focusing on set inference and testing when primitives are set identified. Keywords: Auctions, entry, risk aversion, identification, set inference.
    Keywords: Auctions, Entry, Risk aversion, Identification, Set inference
    JEL: D44 C57
    Date: 2020–09
  8. By: Miguel Casares (Departamento de Economía, Universidad PÌ ublica de Navarra); Paul Gomme (Department of Economics, Concordia University); Hashmat Khan (Department of Economics, Carleton University)
    Abstract: We propose the merge of an epidemiological Susceptible-Infected-Recovered (SIR) model with a macroeconomic model based on the optimizing behavior of representative agents. In the integrated model, the virus contagion depends on the endogenously deter- mined number of daily interpersonal contacts of individuals. These contacts may occur during both economic activities (consumption, working) and social activities. The rational behavior of households to determine consumption and work hours are affected by the virus spread because of a ‘fear of contagion’ term in their utility function. Social con- tacts are also included in the utility function in this case providing a positive marginal satisfaction. Other key features of the model are (i) a time-varying contagion probability to capture variations in public health preventative actions, (ii) asymptomatic virus transmission, (iii) a quarantine index capturing the scale of testing and effectiveness of surveillance (e.g., tracing and tracking, the speed of the process), (iv) telework, and (v) business shutdowns in response to the evolution of the contagion curve. The model parameters are calibrated to Ontario data and we present quantitative analyses of a variety of pandemic and economic scenarios relevant for policy makers.
    Date: 2020–08–31
  9. By: Yeon-Koo Che; Jinwoo Kim; Fuhito Kojima; Christopher Thomas Ryan
    Abstract: We characterize Pareto optimality via sequential utilitarian welfare maximization: a utility vector u is Pareto optimal if and only if there exists a finite sequence of nonnegative (and eventually positive) welfare weights such that $u$ maximizes utilitarian welfare with each successive welfare weights among the previous set of maximizers. The characterization can be further related to maximization of a piecewise-linear concave social welfare function and sequential bargaining among agents a la generalized Nash bargaining. We provide conditions enabling simpler utilitarian characterizations and a version of the second welfare
    Date: 2020–08
  10. By: Michael Monoyios
    Abstract: We develop a duality theory for the problem of maximising expected lifetime utility from inter-temporal wealth over an infinite horizon, under the minimal no-arbitrage assumption of No Unbounded Profit with Bounded Risk (NUPBR). We use only deflators, with no arguments involving equivalent martingale measures, so do not require the stronger condition of No Free Lunch with Vanishing Risk (NFLVR). Our formalism also works without alteration for the finite horizon version of the problem. As well as extending work of Bouchard and Pham to any horizon and to a weaker no-arbitrage setting, we obtain a stronger duality statement, because we do not assume by definition that the dual domain is the polar set of the primal space. Instead, we adopt a method akin to that used for inter-temporal consumption problems, developing a supermartingale property of the deflated wealth and its path that yields an infinite horizon budget constraint and serves to define the correct dual variables. The structure of our dual space allows us to show that it is convex, without forcing this property by assumption. We proceed to enlarge the primal and dual domains to confer solidity to them, and use supermartingale convergence results which exploit Fatou convergence, to establish that the enlarged dual domain is the bipolar of the original dual space. The resulting duality theorem shows that all the classical tenets of convex duality hold. Moreover, at the optimum, the deflated wealth process is a potential converging to zero. We work out examples, including a case with a stock whose market price of risk is a three-dimensional Bessel process, so satisfying NUPBR but not NFLVR.
    Date: 2020–08
  11. By: Roy Allen; John Rehbeck
    Abstract: We propose a conceptual framework for counterfactual and welfare analysis for approximate models. Our key assumption is that model approximation error is the same magnitude at new choices as the observed data. Applying the framework to quasilinear utility, we obtain bounds on quantities at new prices using an approximate law of demand. We then bound utility differences between bundles and welfare differences between prices. All bounds are computable as linear programs. We provide detailed analytical results describing how the data map to the bounds including shape restrictions that provide a foundation for plug-in estimation. An application to gasoline demand illustrates the methodology.
    Date: 2020–09
  12. By: Alla Petukhina; Simon Trimborn; Wolfgang Karl H\"ardle; Hermann Elendner
    Abstract: Cryptocurrencies (CCs) have risen rapidly in market capitalization over the last years. Despite striking price volatility, their high average returns have drawn attention to CCs as alternative investment assets for portfolio and risk management. We investigate the utility gains for different types of investors when they consider cryptocurrencies as an addition to their portfolio of traditional assets. We consider risk-averse, return-seeking as well as diversificationpreferring investors who trade along different allocation frequencies, namely daily, weekly or monthly. Out-of-sample performance and diversification benefits are studied for the most popular portfolio-construction rules, including mean-variance optimization, risk-parity, and maximum-diversification strategies, as well as combined strategies. To account for low liquidity in CC markets, we incorporate liquidity constraints via the LIBRO method. Our results show that CCs can improve the risk-return profile of portfolios. In particular, a maximum-diversification strategy (maximizing the Portfolio Diversification Index, PDI) draws appreciably on CCs, and spanning tests clearly indicate that CC returns are non-redundant additions to the investment universe. Though our analysis also shows that illiquidity of CCs potentially reverses the results.
    Date: 2020–09
  13. By: Roth, Yefim; Plonsky, Ori (Technion - Israel Institute of Technology); Shalev, Edith; Erev, Ido
    Abstract: The recent COVID-19 pandemic poses a challenge to policy makers on how to make the population adhere to the social distancing and personal protection rules. The current research compares two ways by which tracking smartphone applications can be used to reduce the frequency of reckless behaviors that spread pandemics. The first involves the addition of alerts that increase the users’ benefit from responsible behavior. The second involves the addition of a rule enforcement mechanism that reduces the users’ benefit from reckless behavior. The effectiveness of the two additions is examined in an experimental study that focuses on an environment in which both additions are expected to be effective under the assumptions that the agents are expected-value maximizers, risk averse, behave in accordance with cumulative prospect theory (Tversky & Kahneman, 1992), or behave in accordance with the Cognitive Hierarchy model (Camerer, Ho & Chong, 2004). The results reveal a substantial advantage to the enforcement application. Indeed, the alerts addition was completely ineffective. The findings align with the small samples hypothesis, suggesting that decision makers tend to select the options that led to the best payoff in a small sample of similar past experiences. In the current context the tendency to rely on a small sample appears to be more consequential than other deviations from rational choice.
    Date: 2020–08–14
  14. By: Can Kizilkale; Rakesh Vohra
    Abstract: Trades based on bilateral (indivisible) contracts can be represented by a network. Vertices correspond to agents while arcs represent the non-price elements of a bilateral contract. Given prices for each arc, agents choose the incident arcs that maximize their utility. We enlarge the model to allow for polymatroidal constraints on the set of contracts that may be traded which can be interpreted as modeling limited one for-one substitution. We show that for two-sided markets there exists a competitive equilibrium however for multi-sided markets this may not be possible.
    Date: 2020–08
  15. By: Tanaka, Yasuhito
    Abstract: We show the existence of involuntary unemployment based on consumers' utility maximization and firms' profit maximization behavior under monopolistic competition with increasing, decreasing or constant returns to scale technology using a three-period overlapping generations (OLG) model with a childhood period as well as younger and older periods. We also analyze the effects of fiscal policy financed by tax and budget deficit (or seigniorage) to realize full-employment under a situation with involuntary unemployment. We show the following results. 1) In order to maintain the steady state where employment increases at some positive rate, we need a budget deficit (Proposition 1). 2) If the full-employment state is realized, we do not need budget deficit to maintain full-employment (Proposition 2).
    Keywords: Involuntary unemployment, Three-period overlapping generations model, Monopolistic competition
    JEL: E12 E24
    Date: 2020–07–02
  16. By: Matthias Sutter; Michael Weyland; Anna Untertrifaller; Manuel Froitzheim
    Abstract: We present the results of a randomized intervention in schools to study how teaching financial literacy affects risk and time preferences of adolescents. Following more than 600 adolescents, aged 16 years on average, over about half a year, we provide causal evidence that teaching financial literacy has significant short-term and longer-term effects on risk and time preferences. Compared to two different control treatments, we find that teaching financial literacy makes subjects more patient, less present-biased, and slightly more risk-averse. Our finding that the intervention changes economic preferences contributes to a better understanding of why financial literacy has been shown to correlate systematically with financial behavior in previous studies. We argue that the link between financial literacy and field behavior works through economic preferences. In our study, the latter are also related in a meaningful way to students’ field behavior.
    Keywords: financial literacy, randomized intervention, risk preferences, time preferences, field experiment
    JEL: C93 D14 I21
    Date: 2020

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