nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2020‒09‒28
seventeen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. On the Utility Function Representability of Lexicographic Preferences By Shi, Bowen; Wang, Gaowang; Zhang, Zhixiang
  2. Risks and optimal migration duration: The role of higher order risk attitudes By Siwar Khelifa
  3. Ambiguity and the Home Currency Bias By Urban Ulrych; Nikola Vasiljevic
  4. Optimal fiscal and monetary policy in economies with capital By Wang, Gaowang; Zou, Heng-fu
  5. Inform Me When It Matters: Cost Salience, Energy Consumption, and Efficiency Investments By Puja Singhal
  6. Gender differences in risky asset behavior: the importance of self-confidence and financial literacy By Andrej Cupák; Pirmin Fessler; Alyssa Schneebaum
  7. Higher Order Risk Preferences: New Experimental Measures, Determinants and Field Behavior By Schneider, Sebastian; Sutter, Matthias
  8. Behavioral Welfare Economics and Risk Preferences: A Bayesian Approach By Gao, Xiaoxue Sherry; Harrison, Glenn; Tchernis, Rusty
  9. Price, Volatility and the Second-Order Economic Theory By Olkhov, Victor
  10. Competing for Time: A Study of Mobile Applications By Han Yuan
  11. The Role of Establishment Size in the City-Size Earnings Premium in Spain By Charly Porcher; Hannah Rubinton; Clara Santamaría
  12. Crisis Impact on the Diversity of Financial Portfolios - Evidence from European Citizens By Dorothea Schäfer; Michael Stöckel; Henriette Weser
  13. What Explains the COVID-19 Stock Market? By Josue Cox; Daniel L. Greenwald; Sydney C. Ludvigson
  14. Identification and Estimation in a Third-Price Auction Model By Andreea Enache; Jean-Pierre Florens
  15. On the value of life By Colignatus, Thomas
  16. The Economic Impacts of Direct Natural Disaster Exposure By Johar, Meliyanni; Johnston, David W.; Shields, Michael A.; Siminski, Peter; Stavrunova, Olena
  17. Revisiting the history of welfare economics By Roger E. Backhouse; Antoinette Baujard; Tamotsu Nishizawa

  1. By: Shi, Bowen; Wang, Gaowang; Zhang, Zhixiang
    Abstract: The paper examines the utility function representability of the lexicographic preferences over multiple attributes. A sufficient and necessary condition is provided: a lexicographic preference is utility function representable if and only if there is at most one attribute with uncountable levels and when such an attribute exists, it is the least important one. An auxiliary result of independent interest for general rational preferences is proved stating that the class of utility function representable sets is closed in countable unions under some mild condition.
    Keywords: Lexicographic Preference; Utility Function Representation; Representable Class; Pseudo-continuous Points
    JEL: D0
    Date: 2020–08–22
  2. By: Siwar Khelifa (Univ Lyon, Université Lumière Lyon 2, GATE UMR 5824, F-69130 Ecully, France)
    Abstract: Using a bivariate expected utility framework, we develop a two-period model where households determine, in the presence of risks, the parents' migration duration when children are left behind. Our model suggests that the optimal migration duration may respond differently to an increase in a given risk. We provide conditions under which it is optimal for households to decrease the parents' migration duration despite an income risk in the place of origin, and to increase it even though the income in the place of destination is risky. The idea of preference for "harm disaggregation" is used to explain the results. In the absence of uncertainty, we also show the role of the interaction between child human capital and wealth in the household's utility function in determining the optimal migration duration of parents. Empirical implications of this analysis are presented in the last part of the paper.
    Keywords: Child human capital, Higher order risk attitudes, Labor migration, Nth degree Risk, Stochastic dominance
    JEL: D61 D81 J61
    Date: 2020
  3. By: Urban Ulrych (University of Zurich - Department of Banking and Finance; Swiss Finance Institute); Nikola Vasiljevic (University of Zurich, Department of Banking and Finance)
    Abstract: This paper addresses the question of optimal currency exposure for a risk-and-ambiguity-avers international investor. A robust mean-variance model with smooth ambiguity preferences is used to derive the optimal currency exposure. In the theoretical part, we show that the sample-efficient currency demand can be calculated as the solution to a generalized ridge regression. Through the lens of these results, we demonstrate that our ambiguity-based model offers a new explanation of the home currency bias. The investor's dislike for model uncertainty induces a disproportionately high currency hedging demand. The empirical analysis of currency overlay strategies employs the foreign exchange, equity, and bond returns over the period from 1999 to 2018. Our out-of-sample back-tests illustrate that accounting for ambiguity enhances the stability of estimated optimal currency exposures and significantly improves the portfolio performance net of transaction costs.
    Keywords: Ambiguity aversion, model uncertainty, optimal currency overlay, generalized ridge regression, international asset allocation
    JEL: D81 D83 F31 G11 G15
    Date: 2020–08
  4. By: Wang, Gaowang; Zou, Heng-fu
    Abstract: We reexamine the optimal fiscal and monetary policy in combined shopping-time monetary models with capital accumulation. Four models are constructed to examine how the production cost of money and the utility from physical capital affect the toolbox of the fiscal and monetary policy. It is shown that the optimality of the Friedman rule hinges on the producing cost of money and capital-in-utility overturns the Chamley-Judd zero capital income taxation theorem. When the production cost of money approaches zero, the Friedman rule is optimal; and when the consumer cares about the utility from capital, the limiting capital income tax is not zero in general.
    Keywords: Transactions technology; Inflation tax; Capital income tax; Friedman rule; Capital in utility.
    JEL: E40 E52 H20 H21
    Date: 2020–09–04
  5. By: Puja Singhal
    Abstract: Effective attention to information may play a prominent role in consumer choice for energy-intensive services and it may simply be a function of receiving timely information when consumption takes place. This paper investigates whether and why the timing of utility bills leads to salience bias in heat energy consumption. In Germany, the 12-month billing period varies across buildings with a significant share of buildings receiving bills during the summer months, when the salience of heating costs is absent or low. I exploit this large-scale natural experiment in utility billing cycles at the building level to identify the salience effect of costs on energy consumption and the underlying heterogeneity in the average treatment effect. I find new evidence for consumer inattention to energy costs: consumers that are billed for heating during off-winter months demand more heat energy annually. Results suggest that households are paying attention to their heating costs in the first three months of the 12-month billing period. As a result, bills immediately before the winter heating season are most effective, allowing ample opportunity to adjust consumption. I show that salience bias in consumption is persistent and pervasive – affecting households in all regions and building/technology type. Engaging energy users with salient bills, not necessarily more frequent, has the potential to reduce energy consumption in the residential sector significantly. This paper further examines whether enduring differences in consumer inattention to energy costs had a long-run impact on thermal efficiency investments by building owners – with implications for the energy-efficiency gap.
    Keywords: Heating bills, natural experiment, cost salience, consumer inattention, energy consumption, energy efficiency
    JEL: D12 Q41 Q58 Q52
    Date: 2020
  6. By: Andrej Cupák (Research Department, National Bank of Slovakia); Pirmin Fessler (Foreign Research Division, Oesterreichische Nationalbank); Alyssa Schneebaum (Department of Economics, Vienna University of Economics and Business)
    Abstract: Women are less likely than men to hold risky financial assets, a fact that has often been attributed to differences in risk aversion and, more recently, to differences in financial literacy and investor confidence. This paper studies the role of individuals’ confidence in their own financial literacy in explaining the gender gap in investment in risky assets, while controlling for actual financial literacy and a measure of risk aversion. It is the first paper to assess the role of confidence independent of actual financial knowledge for a large set of countries and it is the first to explore the role of confidence by using counterfactual decomposition techniques. Results from our analysis confirm recent findings of modern behavioral finance: confidence is a strong determinant of risky financial behavior and accounts for a large part of the gender gap.
    Keywords: self-confidence, financial literacy, financial behavior, gender, decomposition
    JEL: D14 D91 I20 G11
    Date: 2020–09
  7. By: Schneider, Sebastian (Max Planck Institute for Research on Collective Goods); Sutter, Matthias (Max Planck Institute for Research on Collective Goods)
    Abstract: We use a novel method to elicit and measure higher order risk preferences (prudence and temperance) in an experiment with 658 adolescents. In line with theoretical predictions, we find that higher order risk preferences particularly prudence are strongly related to adolescents' field behavior, including their financial decision making, eco-friendly behavior, and health status, including addictive behavior. Most importantly, we show that dropping prudence and temperance from the analysis of students' field behavior would yield largely misleading conclusions about the relation of risk aversion to these domains of field behavior. Thus our paper puts previous work that ignored higher order risk preferences into an encompassing perspective and claries which orders of risk preferences can help understand field behavior of adolescents.
    Keywords: higher order risk preferences, prudence, temperance, risk aversion, field behavior, adolescents, health, addictive behavior, smartphone addiction, experiment
    JEL: C93 D81 D91 J13
    Date: 2020–08
  8. By: Gao, Xiaoxue Sherry (University of Massachusetts Amherst); Harrison, Glenn (Georgia State University, CEAR); Tchernis, Rusty (Georgia State University)
    Abstract: We propose the use of Bayesian estimation of risk preferences of individuals for applications of behavioral welfare economics to evaluate observed choices that involve risk. Bayesian estimation provides more systematic control of the use of informative priors over inferences about risk preferences for each individual in a sample. We demonstrate that these methods make a difference to the rigorous normative evaluation of decisions in a case study of insurance purchases. We also show that hierarchical Bayesian methods can be used to infer welfare reliably and efficiently even with significantly reduced demands on the number of choices that each subject has to make. Finally, we illustrate the natural use of Bayesian methods in the adaptive evaluation of welfare.
    Keywords: behavioral welfare economics, Bayesian Analysis, risk preferences, insurance
    JEL: D6 C11 D81
    Date: 2020–08
  9. By: Olkhov, Victor
    Abstract: This paper considers price volatility as the reason for description of the second-degree economic variables, trades and expectations aggregated during certain time interval Δ. We call it - the second-order economic theory. The n-th degree products of costs and volumes of trades, performed by economic agents during interval Δ determine price n-th statistical moments. First two price statistical moments define volatility. To model volatility one needs description of the squares of trades aggregated during interval Δ. To describe price probability one needs all n-th statistical moments of price but that is almost impossible. We define squares of agent’s trades and macro expectations those approve the second-degree trades aggregated during interval Δ. We believe that agents perform trades under action of multiple expectations. We derive equations on the second-degree trades and expectations in economic space. As economic space we regard numerical continuous risk grades. Numerical risk grades are discussed at least for 80 years. We propose that econometrics permit accomplish risk assessment for almost all economic agents. Agents risk ratings distribute agents by economic space and define densities of macro second-degree trades and expectations. In the linear approximation we derive mean square price and volatility disturbances as functions of the first and second-degree trades disturbances. In simple approximation numerous expectations and their perturbations can cause small harmonic oscillations of the second-degree trades disturbances and induce harmonic oscillations of price and volatility perturbations.
    Keywords: volatility; economic theory; market trades; expectations; price probability
    JEL: C1 D4 E4 G1 G2
    Date: 2020–09–06
  10. By: Han Yuan
    Abstract: A smartphone user allocates her time to multiple mobile applications. To study the competitive relationship among apps, I develop a discrete-continuous model of time allocation with a binding time constraint and estimate it with a weekly panel of app usage in China. If two apps are often used together, it is because either they are complements or the preferences of the two apps are positively correlated. To disentangle complementarity (substitutability) from correlation in preferences, I use the exclusion restriction that updates of an app should affect the utility of this app but not those of other apps. I estimate the model on three pairs of apps (substitutes, complements, and independent apps). I recover a reasonable competition pattern and simulate mergers of the three pairs of apps. I find that a seemingly innocuous merger of independent apps can hurt consumers due to the binding time constraint. My results confirm that users and firms can both benefit from a merger of complements. I also find that usage-based pricing leads to higher profits and total surplus compared with subscription pricing because it enables price discrimination based on usage.
    JEL: L11 L40 M31
    Date: 2020–09–18
  11. By: Charly Porcher; Hannah Rubinton; Clara Santamaría
    Abstract: Both large establishments and large cities are known to offer workers an earnings premium. In this paper, we show that these two premia are closely linked by documenting a new fact: when workers move to a large city, they also move to larger establishments. We then ask how much of the city- size earnings premium can be attributed to transitions to larger and better-paying establishments. Using administrative data from Spain, we find that 38 percent of the city-size earnings premium can be explained by establishment-size composition. Most of the gains from the transition to larger establishments realize in the short-term upon moving to the large city. Establishment size explains 29 percent of the short-term gains, but only 5 percent of the medium-term gains that accrue as workers gain experience in the large city. The small contribution to the medium-term gains is due to two facts: first, within large cities workers transition to large establishments only slightly faster than in smaller cities; second, the relationship between earnings and establishment size is weaker in large cities.
    Keywords: City-size wage premium; Establishment-size wage premium
    JEL: R12
    Date: 2020–09–04
  12. By: Dorothea Schäfer; Michael Stöckel; Henriette Weser
    Abstract: Since the 2008 Lehman bankruptcy, it is clearly shown that global economic and financial crises present major challenges to private households, requiring from them, a high level of shock absorption capacity. According to the old adage, “Do not put all the eggs in one basket”, resilience depends, to a large extent on financial diversification. So far, especially for Europe, little is known about whether and how the Great Financial Crisis (GFC) affected the diversity of private households’ investment portfolios. We tackle this research gap and explore the impact of the GFC on portfolio diversity of European private households. Our European focus complements Sierminska and Silber (2019) who explore the diversification behaviour of US households after the Lehman insolvency. Our study reveals a significant decrease in the diversity of financial portfolios. This finding is robust across distinct model specifications. In response to the GFC, evidence suggests that European households adjusted the diversity of their financial portfolio in the opposite directions to that of US households.
    Keywords: Financial and economic crisis, household finance, portfolio diversification, Shannon entropy index, Gini-Simpson diversity index, background risk, risk aversion
    JEL: D14 G11 G01
    Date: 2020
  13. By: Josue Cox; Daniel L. Greenwald; Sydney C. Ludvigson
    Abstract: What explains stock market behavior in the early weeks of the coronavirus pandemic? Estimates from a dynamic asset pricing model point to wild fluctuations in the pricing of stock market risk, driven by shifts in risk aversion or sentiment. We find further evidence that the Federal Reserve played a role in these fluctuations, via a series of announcements outlining unprecedented steps to provide several trillion dollars in loans to support the economy. As of July 31 of 2020, however, only a tiny fraction of the credit that the central bank announced it stood ready to provide in early April had been extended, reinforcing the conclusion that market movements during COVID-19 have been more reflective of sentiment than substance.
    JEL: G12 G28
    Date: 2020–09
  14. By: Andreea Enache (SSE - Stockholm School of Economics); Jean-Pierre Florens (TSE - Toulouse School of Economics - UT1 - Université Toulouse 1 Capitole - EHESS - École des hautes études en sciences sociales - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement)
    Abstract: The first novelty of this paper is that we show global identification of the private values distribution in a sealed-bid third-price auction model using a fully nonparametric methodology. The second novelty of the paper comes from the study of the identification and estimation of the model using a quantile approach. We consider an i.i.d. private values environment with risk-averse bidders. In the first place, we consider the case where the risk-aversion parameter is known. We show that the speed of convergence in process of our nonparametric estimator produces at the root-n parametric rate and we explain the intuition behind this apparently surprising result. Next, we consider that the risk-aversion parameter is unknown and we locally identify it using exogenous variation in the number of participants. We extend our procedure to the case where we observe only the bids corresponding to the transaction prices, and we generalize the model so as to account for the presence of exogenous variables. The methodological toolbox used to analyse identification of the third-price auction model can be employed in the study of other games of incomplete information. Our results are interesting also from a policy perspective,as some authors recommend the use of the third-price auction format for certain Internet auctions. Moreover, we contribute to the econometric literature on auctions using a quantile approach.
    Keywords: structural nonparametric estimation,nonlinear inverse problems,global identification,functional convergence of estimators,third-price auction mode
    Date: 2020–06
  15. By: Colignatus, Thomas
    Abstract: The national budget affects life and death via its allocations in areas such as traffic safety, flood control, public health and the like. When the cost-effectiveness of an intervention is evaluated, common effect measures are the number of lives extended (saved) and the expected life-years gained. The latter are usually adjusted for quality of life, giving QALYs, and discounted. In models that support decision making on the national aggregates, the subjects can be reduced to representative agents that are scored only on these dimensions. The lives extended measure is impartial to age and sex. The life-years measures however are biased in age and sex, since young people have a higher life expectancy than the old and women have a higher life expectancy than men, and policy advice might reflect that bias. It seems advisable to devise a measure that is more impartial and fair with respect to the age groups and the sexes. An alternative is to value a single life at 100%, and to measure the life-years gain with respect to that 100%. In addition, rather than fine-tune policy with interpersonal utility comparisons, one could choose a utility norm for the representative agent. A possible norm for time preference and diminishing marginal utility of life is the square root. The square root is easier to communicate than logarithmic utility or some rate of discount, but has comparable effect. A life of 100 years then has value 10, a life of 25 years has value 5, so that by age 25 half of life is passed. The considerations of both 100% range and square root utility lead to the following age & sex adjusted gain measure. When a person has age a, experiences an event (accident, disease) with a life expectancy of d years, but might have an intervention such that the life expectancy could become e, then the current effect measures are the single life saved and the absolute life-years gain x = e - d, but the proposed compromise gain measure is g[x | a, d] = Sqrt[x] / Sqrt[a + d + x]. The square root gives the utility of the representative agent, g gives the impact for interpersonal comparison, and aggregate utility is found by summing the gi over the individuals i. For example, saving (from acute death, d = 0) a baby (a = 0) has the same value, namely 1, whether it is a boy (life expectancy at birth, x = 75.94) or girl (x = 80.71) (data Statistics Netherlands 2002). As another example, let the unit share s = x / (a + e) be 25% for one person and 81% for another person so that the last person would weigh more than three times as much in this respect. For above gain measure, g = Sqrt[s] and the weight ratio becomes 50% / 90%, so that the last person now weighs less than half so that there is more equality. The paper compares various gain measures within the context of social welfare maximization. The update in 2020 has a more explicit discussion of Fair Innings (FI) and Proportional Shortfall (PS), and it is shown in a better manner that the UnitSqrt can be an acceptable compromise.
    Keywords: social welfare, decision making, risk, health, quality of life, cost-effectiveness, discounting, fair innings, proportional shortfall, unitsqrt
    JEL: D63 H51 I13 I14 J17
    Date: 2020–08–20
  16. By: Johar, Meliyanni (University of Technology, Sydney); Johnston, David W. (Monash University); Shields, Michael A. (Monash University); Siminski, Peter (University of Technology, Sydney); Stavrunova, Olena (University of Technology, Sydney)
    Abstract: This paper studies how having your home damaged or destroyed by a natural disaster impacts on economic and financial outcomes. Our context is Australia, where disasters are frequent. Estimates of regression models with individual, area and time fixed-effects, applied to 10 waves of data (2009-2018), indicate that residential destruction has no average impact on employment and income, but increases financial hardship and financial risk aversion. These impacts are generally short-lived, larger for renters than home owners, and greater for smaller isolated disasters. Using a Group Fixed Effects estimator, we find that around 20% of the population have low resilience to financial shocks, and for these individuals we find a substantive increase in financial hardships. The most vulnerable are the young, single parents, those in poor health, those of lower socioeconomic status, and those with little social support. These results can help target government aid after future natural disasters to those with the greatest need.
    Keywords: natural disasters, financial hardship, risk aversion, mental health, resilience
    JEL: Q54 J21 I31 C23 H84
    Date: 2020–08
  17. By: Roger E. Backhouse (University of Birmingham and Erasmus University Rotterdam); Antoinette Baujard (Univ Lyon, UJM Saint-Etienne, GATE UMR 5824, F-42023 Saint-Etienne, France); Tamotsu Nishizawa (Teikyo University, Faculty of Economics, Tokyo)
    Abstract: Our forthcoming book, Welfare Theory, Public Action and Ethical Values challenges the belief that, until modern welfare economics introduced issues such as justice, freedom and equality, economists adopted what Amartya Sen called “welfarism.” This is the belief that the welfare of society depends solely on the ordinal utilities of the individuals making up the society. Containing chapters on some of the leading twentieth-century economists, including Walras, Marshall, Pigou, Pareto, Samuelson, Musgrave, Hicks, Arrow, Coase and Sen, as well as lesser-known figures, including Ruskin, Hobson and contributors to the literature on capabilities, the book argues that, whatever their theoretical commitments, when economists have considered practical problems they have adopted a wider range of ethical values, attaching weight to equality, justice and freedom. Part 1 explains the concepts of welfarism and non-welfarism and explores ways in which economists have departed from welfarism when tackling practical problems and public policy. Part 2 explores the reasons for this. When moving away from abstract theories to consider practical problems it is often hard not to take an ethical position and economists have often been willing to do so. We conclude that economics needs to recognise this and to become more of a moral science.
    Keywords: Welfarism, non-welfarism, welfare, public policy, ethics, economics, individualism
    JEL: B21 B31 B41 D63 I31
    Date: 2020

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