nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2020‒11‒23
23 papers chosen by

  1. Mechanism Design for Unequal Societies By Marco Reuter; Carl-Christian Groh
  2. The importance of dynamic risk constraints for limited liability operators By John Armstrong; Damiano Brigo; Alex S. L. Tse
  3. Duality and deep learning for optimal consumption with randomly terminating income By Ashley Davey; Michael Monoyios; Harry Zheng
  4. Risk Preferences and Training Investments By Caliendo, Marco; Cobb-Clark, Deborah A.; Obst, Cosima; Uhlendorff, Arne
  5. Higher Order Risk Preferences: Experimental Measures, Determinants and Related Field Behavior By Schneider, Sebastian O.; Sutter, Matthias
  6. A general framework for studying contests By Bastani, Spencer; Giebe, Thomas; Gürtler, Oliver
  7. Higher Order Risk Preferences: New Experimental Measures, Determinants and Field Behavior By Sebastian Schneider; Matthias Sutter
  8. On Convexity in Games with Externalities By José María Alsonso-Maijide; Mikel Álvarez-Mozos; María Gloria Fiestras-Janeiro; Andrés Jiménez-Losada
  9. Optimal Monetary Policy with Heterogeneous Agents By Galo Nuño; Carlos Thomas
  10. Insights into Fairness through Trust: Multi-scale Trust Quantification for Financial Deep Learning By Alexander Wong; Andrew Hryniowski; Xiao Yu Wang
  11. How Long-Term Contracts can Mitigate Inefficient Renegotiation Arising Due to Loss Aversion By Göller, Daniel
  12. Loss Averse Depositors and Monetary Policy around Zero By Christian Stettler
  13. Involuntary unemployment under ongoing nominal wage rate decline in overlapping generations model By Tanaka, Yasuhito
  14. Preference Estimation in Deferred Acceptance with Partial School Rankings By Shanjukta Nath
  15. Financial literacy, risk and time preferences – Results from a randomized educational intervention By Matthias Sutter; Michael Weyland; Anna Untertrifaller; Manuel Froitzheim
  16. Intensity-Efficient Allocations By Georgios Gerasimou
  17. A Strictly Economic Explanation of Gender Roles: The Lasting Legacy of the Plough. By Alessandro Cigno
  18. Nonparametric Identification of Production Function, Total Factor Productivity, and Markup from Revenue Data By Hiroyuki Kasahara; Yoichi Sugita
  19. Inefficiency and Regulation in Credence Goods Markets with Altruistic Experts By Farukh, Razi; Kerkhof, Anna; Loebbing, Jonas
  20. Does the Fundamental Transformation Deter Trade? An Experiment By Christoph Engel; Eric Helland
  21. Productivity Shocks, Long-Term Contracts and Earnings Dynamics By Neele Balke; Thibaut Lamadon
  22. Asymmetric Demand Response when Prices Increase and Decrease: The Case of Child Healthcare By Toshiaki Iizuka; Hitoshi Shigeoka
  23. Asset Allocation via Machine Learning and Applications to Equity Portfolio Management By Qing Yang; Zhenning Hong; Ruyan Tian; Tingting Ye; Liangliang Zhang

  1. By: Marco Reuter; Carl-Christian Groh
    Abstract: We study optimal mechanisms for a utilitarian designer who seeks to assign multiple units of an indivisible good to a group of agents with unit demand. The agents have heterogeneous marginal utilities of money, which implies that utility is not perfectly transferable between them. Heterogeneous marginal utilities of money may naturally arise in environments where agents have different wealth endowments. We show that the ex post efficient allocation rule is not optimal in our setting. Firstly, a high willingness to pay may stem from a low marginal utility of money. Moreover, the transfer rule does not only facilitate implementation of the desired social choice function in our setting, but also directly affects social welfare. In the optimal mechanism, rationing may occur, which entails a conflict between ex ante and ex post efficiency. In an extension, we show that it is still not utilitarian optimal to allocate the good solely based on willingness to pay even when redistribution is not possible. Finally, we highlight how our mechanism can be implemented as an auction with minimum bids and bidding subsidies.
    Keywords: optimal mechanism design, redistribution, inequality, auctions
    JEL: D44 D47 D61 D63 D82
    Date: 2020–11
  2. By: John Armstrong; Damiano Brigo; Alex S. L. Tse
    Abstract: Previous literature shows that prevalent risk measures such as Value at Risk or Expected Shortfall are ineffective to curb excessive risk-taking by a tail-risk-seeking trader with S-shaped utility function in the context of portfolio optimisation. However, these conclusions hold only when the constraints are static in the sense that the risk measure is just applied to the terminal portfolio value. In this paper, we consider a portfolio optimisation problem featuring S-shaped utility and a dynamic risk constraint which is imposed throughout the entire trading horizon. Provided that the risk control policy is sufficiently strict relative to the asset performance, the trader's portfolio strategies and the resulting maximal expected utility can be effectively constrained by a dynamic risk measure. Finally, we argue that dynamic risk constraints might still be ineffective if the trader has access to a derivatives market.
    Date: 2020–11
  3. By: Ashley Davey; Michael Monoyios; Harry Zheng
    Abstract: We establish a rigorous duality theory for a finite horizon problem of optimal consumption in the presence of an income stream that can terminate randomly at an exponentially distributed time, independent of the asset prices. We thus close a duality gap encountered by Vellekoop and Davis in an infinite horizon version of this problem. Nearly all the classical tenets of duality theory are found to hold, with the notable exception that the marginal utility of initial wealth at zero is finite. The intuition is that the agent will receive some income, no matter how early it terminates, so is not infinitely penalised for having zero initial capital. We then solve the problem numerically, with an additional terminal wealth objective, using deep learning. We transform the problem with randomly terminating income into one that no longer depends on the jump component but has an additional inter-temporal wealth objective. We then numerically solve the second order backward stochastic differential equations (2BSDEs), in both the primal and dual dimensions, to find the optimal control and tight lower and upper bounds for the value function.
    Date: 2020–10
  4. By: Caliendo, Marco (University of Potsdam); Cobb-Clark, Deborah A. (University of Sydney); Obst, Cosima (University of Potsdam); Uhlendorff, Arne (CREST)
    Abstract: We analyze workers' risk preferences and training investments. Our conceptual frame- work differentiates between the investment risk and insurance mechanisms underpin- ning training decisions. Investment risk leads risk-averse workers to train less; they undertake more training if it insures them against future losses. We use the German Socio-Economic Panel (SOEP) to demonstrate that risk affinity is associated with more training, implying that, on average, investment risks dominate the insurance benefits of training. Crucially, this relationship is evident only for general training; there is no relationship between risk attitudes and specific training. Thus, as expected, risk preferences matter more when skills are transferable – and workers have a vested interest in training outcomes – than when they are not. Finally, we provide evidence that the insurance benefits of training are concentrated among workers with uncertain employment relationships or limited access to public insurance schemes.
    Keywords: human capital investment, work-related training, risk preferences
    JEL: J24 C23 D81
    Date: 2020–10
  5. By: Schneider, Sebastian O.; Sutter, Matthias
    Abstract: Higher order risk preferences are well-known for their relation with precautionary saving or portfolio allocation. Theoretically, they are also connected with other important behavior, such as health-related or eco-friendly behavior, but these relations have never been investigated with field data. In a large-scale experiment with 658 adolescents, we relate experimental measures of higher order risk preferences with field behavior. Field behavior is collected in an extensive survey, where we focus on general risk taking, the environmental and the health domain, particularly on addictive behavior. Using a novel method allowing the experimental elicitation of intensities of prudence and temperance, we find females behaving more risk averse, prudent and temperant, and high-ability students behaving less risk averse and temperant. We confirm previous findings on financial decision making and higher order risk preferences, and find that prudence is a strong predictor for health-related behavior: An index capturing the obsessive use of smartphones is predicted significantly by prudence, but not by risk aversion or temperance.
    Keywords: Higher order risk,prudence,temperance,field behavior,adolescents,health,addictive behavior,smartphone addiction
    JEL: C93 D81 D91 J13
    Date: 2020
  6. By: Bastani, Spencer; Giebe, Thomas; Gürtler, Oliver
    Abstract: We develop a general framework to study contests, containing the well-known models of Tullock (1980) and Lazear & Rosen (1981) as special cases. The contest outcome depends on players' effort and skill, the latter being subject to symmetric uncertainty. The model is tractable, because a symmetric equilibrium exists under general assumptions regarding production technologies and skill distributions. We construct a link between our contest model and expected utility theory and exploit this link to revisit important comparative statics results of contest theory and show how these can be overturned. Finally, we apply our results to study optimal workforce composition.
    Keywords: contest theory,symmetric equilibrium,heterogeneity,risk,decision theory
    JEL: C72 D74 D81 J23 M51
    Date: 2020
  7. By: Sebastian Schneider (Max Planck Institute for Research on Collective Goods, Bonn); Matthias Sutter (Max Planck Institute for Research on Collective Goods, Bonn)
    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 clarifies 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: José María Alsonso-Maijide (Universidade de Santiago de Compostela); Mikel Álvarez-Mozos (Universitat de Barcelona); María Gloria Fiestras-Janeiro (Universidade de Vigo); Andrés Jiménez-Losada (Universidad de Sevilla)
    Abstract: We introduce new notions of superadditivity and convexity for games with coalitional externalities. We show parallel results to the classic ones for transferable utility games without externalities. In superadditive games the grand coalition is the most efficient organization of agents. The convexity of a game is equivalent to having non decreasing contributions to larger embedded coalitions. We also see that convex games can only have negative externalities.
    Keywords: Externalities, Partition function, Lattice, Superadditivity, Convexity, Contribution.
    JEL: C71
    Date: 2019
  9. By: Galo Nuño; Carlos Thomas
    Abstract: We analyze optimal monetary policy under commitment in an economy with uninsurable idiosyncratic risk, long-term nominal bonds and costly inflation. Our model features two transmission channels of monetary policy: a Fisher channel, arising from the impact of inflation on the initial price of long-term bonds, and a liquidity channel. The Fisher channel gives the central bank a reason to inflate for redistributive purposes, because debtors have a higher marginal utility than creditors. This inflationary motive fades over time as bonds mature and the central bank pursues a deflationary path to raise bond prices and thus relax borrowing limits. The result is optimal inflation front-loading. Numerically, we find that optimal policy achieves first-order consumption and welfare redistribution vis-à-vis a zero inflation policy.
    Keywords: optimal monetary policy, incomplete markets, Gâteau derivative, nominal debt, inflation, redistributive effects, continuous time
    JEL: E50 E62 F34
    Date: 2020
  10. By: Alexander Wong; Andrew Hryniowski; Xiao Yu Wang
    Abstract: The success of deep learning in recent years have led to a significant increase in interest and prevalence for its adoption to tackle financial services tasks. One particular question that often arises as a barrier to adopting deep learning for financial services is whether the developed financial deep learning models are fair in their predictions, particularly in light of strong governance and regulatory compliance requirements in the financial services industry. A fundamental aspect of fairness that has not been explored in financial deep learning is the concept of trust, whose variations may point to an egocentric view of fairness and thus provide insights into the fairness of models. In this study we explore the feasibility and utility of a multi-scale trust quantification strategy to gain insights into the fairness of a financial deep learning model, particularly under different scenarios at different scales. More specifically, we conduct multi-scale trust quantification on a deep neural network for the purpose of credit card default prediction to study: 1) the overall trustworthiness of the model 2) the trust level under all possible prediction-truth relationships, 3) the trust level across the spectrum of possible predictions, 4) the trust level across different demographic groups (e.g., age, gender, and education), and 5) distribution of overall trust for an individual prediction scenario. The insights for this proof-of-concept study demonstrate that such a multi-scale trust quantification strategy may be helpful for data scientists and regulators in financial services as part of the verification and certification of financial deep learning solutions to gain insights into fairness and trust of these solutions.
    Date: 2020–11
  11. By: Göller, Daniel
    Abstract: A loss averse buyer and seller face an uncertain environment. Should they write a long-term contract or wait until the state of the world has realized? I show that simple long-term contracts perform better than insinuated in Herweg and Schmidt (2015), even though loss aversion makes renegotiation sometimes inefficient. During renegotiation, the outcome induced by the long-term contract constitutes the reference points to which the parties compare gains and losses of the renegotiated transaction. Whereas Herweg and Schmidt assume that the long-term contract is always performed, it is actually preferably that it is not in a "bad" state. This alters the threat-point in renegotiation, making it easier to renegotiate and thus improves the performance of long-term contracts. Specific performance contracts perform better than in Herweg and Schmidt but are still problematic since one can not always prevent that the contract is enforced when it should not. Option contracts perform much better since only one party has the ex post trade decision and it is thus much easier to prevent that the contract is inefficiently enforced due to loss aversion. My findings suggest that loss aversion alone cannot explain why parties sometimes abstain from writing beneficial long-term contracts, but gives important insights on how long-term contracts should be written when parties are aware they are loss averse.
    Keywords: Incomplete Contracts,Behavioral Contract Theory,Reference points,Holdup,Renegotiation
    JEL: D86
    Date: 2020
  12. By: Christian Stettler (KOF Swiss Economic Institute, ETH Zurich, Switzerland)
    Abstract: Recent experience from Europe and Japan shows that commercial banks generally pass negative short-term policy rates on to wholesale depositors, such as insurances and pension funds. Yet, they refrain from charging negative rates to ordinary retail customers. This paper asks whether the existing evidence on the inverse relationship between market experience and the degree of loss aversion can explain this transmission pattern. To this end, I allow for loss averse depositors within a simple two-period di erentiated products duopoly with switching costs. It turns out that if depositors are especially averse to negative deposit rates, banks keep deposit rates at zero as policy rates decline, while accepting squeezed and possibly negative deposit margins. The lowest current policy rate at which the bankingsystem is willing to shield depositors from a negative deposit rate decreases with increasing i) degrees of loss aversion; ii) levels of switching costs; and iii) market expectations about the future policy rate. A calibration of the model indicates how low central banks could e ectively go without taking steps to make paper currency more costly.
    Keywords: Deposits, effective lower bound, loss aversion, negative interest rates
    JEL: D43 E43 E52 E58 G21 L13
    Date: 2020–04
  13. By: Tanaka, Yasuhito
    Abstract: We analyze involuntary unemployment based on consumers’ utility maximization and firms’ profit maximization behavior with ongoing nominal wage rate decline. We consider a three-periods overlapping generations (OLG) model with a childhood period as well as younger and older periods under monopolistic competition with increasing, decreasing or constant returns to scale technology. We examine the existenbce of involuntary unemployment in that model with ongoing mominal wage rate decline (or deflation). Even if the nominal wage rate declines, we have a steady state with involuntary unemployment and constant output and employment. We need budget deficit or budget surplus to maintain the steady state depending on whether real balance effect is positive or negative. Also we examine the possibility to achieve full-employment by fiscal policy
    Keywords: Involuntary unemployment, Three-periods overlapping generations model, Monopolistic competition, Ongoing nominal wage rate decline, Real balance effect.
    JEL: E12 E24
    Date: 2020–10–28
  14. By: Shanjukta Nath
    Abstract: The Deferred Acceptance algorithm is a popular school allocation mechanism thanks to its strategy proofness. However, with application costs, strategy proofness fails, leading to an identification problem. In this paper, I address this identification problem by developing a new Threshold Rank setting that models the entire rank order list as a one-step utility maximization problem. I apply this framework to study student assignments in Chile. There are three critical contributions of the paper. I develop a recursive algorithm to compute the likelihood of my one-step decision model. Partial identification is addressed by incorporating the outside value and the expected probability of admission into a linear cost framework. The empirical application reveals that although school proximity is a vital variable in school choice, student ability is critical for ranking high academic score schools. The results suggest that policy interventions such as tutoring aimed at improving student ability can help increase the representation of low-income low-ability students in better quality schools in Chile.
    Date: 2020–10
  15. By: Matthias Sutter (Max Planck Institute for Research on Collective Goods, Bonn); 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: 2020–08
  16. By: Georgios Gerasimou
    Abstract: We study the problem of allocating $n$ indivisible objects to $n$ agents when the latter can express strict and purely ordinal preferences and preference intensities. We suggest a rank-based criterion to make ordinal interpersonal comparisons of preference intensities in such an environment without assuming interpersonally comparable utilities. We then define an allocation to be "intensity-efficient" if it is Pareto efficient and also such that, whenever another allocation assigns the same pairs of objects to the same pairs of agents but in a "flipped" way, then the former assigns the commonly preferred alternative within every such pair to the agent who prefers it more. We show that an intensity-efficient allocation exists for all 1,728 profiles when $n=3$.
    Date: 2020–11
  17. By: Alessandro Cigno
    Abstract: We show that the descendants of ancient farmers may have an interest in marrying among themselves, and thus maintaining the gendered division of labour, originally justified on comparative-advantage grounds by the advent of the plough, even after they emigrate to a modern industrial economy where individual productivity depends on education rather than physical characteristics. The result rests on the argument that, if efficiency requires the more productive spouse to specialize in raising income, and the less productive one in raising children, irrespective of gender, an efficient domestic equilibrium will be implemented by a costlessly enforceable pre-marital contract stipulating that the husband should do the former and the wife the latter. A con-tract may not be needed, however, if time spent with children gives direct utility, because an effi cient equilibrium may then be characterized by little or no division of labour.
    Keywords: plough, comparative advantage, gender, matching, hold-up problem, contract enforcement, migration
    JEL: C78 D02 J16 J61
    Date: 2020
  18. By: Hiroyuki Kasahara; Yoichi Sugita
    Abstract: Commonly used methods of production function and markup estimation assume that a firm's output quantity can be observed as data, but typical datasets contain only revenue, not output quantity. We examine the nonparametric identification of production function and markup from revenue data when a firm faces a general nonparametri demand function under imperfect competition. Under standard assumptions, we provide the constructive nonparametric identification of various firm-level objects: gross production function, total factor productivity, price markups over marginal costs, output prices, output quantities, a demand system, and a representative consumer's utility function.
    Date: 2020–10
  19. By: Farukh, Razi; Kerkhof, Anna; Loebbing, Jonas
    Abstract: We study a credence goods problem - that is, a moral hazard problem with non-contractible outcome - where altruistic experts (the agents) care both about their income and the utility of consumers (the principals). Experts' preferences over income and their consumers' utility are convex, such that experts care less for consumers when their financial situation is bad. In a market setting with multiple consumers per expert, a cross-consumer externality arises: one consumer's payment raises the expert's income, which makes the non-selfish part of preferences more important and thereby induces the expert to provide higher quality services to all consumers. The externality renders the market outcome inefficient. Price regulation partially overcomes this inefficiency and Pareto-improves upon the market outcome. If market entry of experts is endogenous, price regulation should be accompanied by licensing arrangements that cap the number of experts in the market. Our theory provides a novel rationale for the wide-spread use of price regulation and licensing in real-world markets for expert services.
    Keywords: altruism,asymmetric information,common agency,credence goods,expert services,externality,inefficiency,moral hazard,regulation
    JEL: D64 D82 D86 L15 L51
    Date: 2020
  20. By: Christoph Engel (Max Planck Institute for Research on Collective Goods); Eric Helland (Claremont McKenna College)
    Abstract: Oliver Williamson has coined the term “fundamental transformation”. It captures the following situation: before they strike a deal, buyer and seller are protected by competition. Yet thereafter they find themselves in a bilateral monopoly. With common knowledge of standard preferences, both sides conclude the contract regardless if its expected value exceeds their outside options. We run an experiment to test whether additional behavioral reasons deter mutually beneficial trade. If the risk materializes, another individual makes a windfall profit. She does so by intentionally exploiting the first individual. The first individual is let down, although she has knowingly exposed herself to this risk. Participants sell the opportunity to enter the contractual relationship at a price below its expected value. This effect is driven by risk aversion, and already present if the risk is stochastic. Behavioral effects are heterogeneous. About a quarter of participants exhibit the hypothesized additional deterrent effect.
    Keywords: fundamental transformation, bilateral monopoly, sunk cost, Oliver Williamson, windfall profit, exploitation, let down aversion
    JEL: B21 C91 D22 D43 K12 L12 L14
    Date: 2020–09
  21. By: Neele Balke; Thibaut Lamadon
    Abstract: This paper examines how employer- and worker-specific productivity shocks transmit to earnings and employment in an economy with search frictions and firm commitment. We develop an equilibrium search model with worker and firm shocks and characterize the optimal contract offered by competing firms to attract and retain workers. In equilibrium, risk-neutral firms provide only partial insurance against shocks to risk-averse workers and offer contingent contracts, where payments are backloaded in good times and frontloaded in bad times. We prove that there exists a unique spot target wage, which serves as an attraction point for smooth wage adjustments. The structural model is estimated on matched employer-employee data from Sweden. The estimates indicate that firms absorb persistent worker and firm shocks, with respective passthrough values of 27 and 11%, but price permanent worker differences, a large contributor (32%) to variations in wages. A large share of the earnings growth variance can be attributed to job mobility, which interacts with productivity shocks. We evaluate the effects of redistributive policies and find that almost 40% of government-provided insurance is undone by crowding out firm-provided insurance.
    JEL: E24 J31 J41 J64
    Date: 2020–11
  22. By: Toshiaki Iizuka; Hitoshi Shigeoka
    Abstract: This study tests whether demand responds symmetrically to price increases and decreases—a seemingly obvious proposition under conventional demand theory that has not been rigorously tested. Exploiting rapid expansion in municipal subsidies for child healthcare in a difference-in-differences framework, we find evidence against it: when coinsurance, our price measure, increases from 0% to 30%, the demand response is more than twice that to a price decrease from 30% to 0%, a result consistent with loss aversion. This result indicates that, while economists and policymakers pay little attention, the price change direction matters, and that welfare analysis should incorporate this direction.
    JEL: I11 I13 I18 J13
    Date: 2020–11
  23. By: Qing Yang; Zhenning Hong; Ruyan Tian; Tingting Ye; Liangliang Zhang
    Abstract: In this paper, we document a novel machine learning based bottom-up approach for static and dynamic portfolio optimization on, potentially, a large number of assets. The methodology overcomes many major difficulties arising in current optimization schemes. For example, we no longer need to compute the covariance matrix and its inverse for mean-variance optimization, therefore the method is immune from the estimation error on this quantity. Moreover, no explicit calls of optimization routines are needed. Applications to a bottom-up mean-variance-skewness-kurtosis or CRRA (Constant Relative Risk Aversion) optimization with short-sale portfolio constraints in both simulation and real market (China A-shares and U.S. equity markets) environments are studied and shown to perform very well.
    Date: 2020–11

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