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on Utility Models and Prospect Theory |
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Issue of 2021‒05‒10
twenty-two papers chosen by |
| By: | Appelbaum, Elie; Melatos, Mark |
| Abstract: | We investigate preferential trade agreement (PTA) formation when risk averse countries face demand uncertainty and, hence, have an insurance motive for pursuing trade integration. In this environment, when deciding which type of PTA - if any - they wish to form, countries seek to maximise their net welfare; that is, their expected utility less a risk premium. The desire for insurance influences, not just whether a particular PTA forms, but also the preferred depth of integration. We analyze the insurance implications of free trade agreements (FTAs), customs unions (CUs), and countries choosing to stand alone. We further distinguish between shallow CUs and deep CUs; in the former, members maximise the sum of their individual net welfares, while in the latter they maximise the net value of the sum of their individual expected welfares. We show that differences in country risk attitudes and the levels of risk they face, as well as the degree to which these risks are correlated with each other, each, and together, influence the formation and design of TAs. When countries’ demands are uncorrelated, they form a deep CU if their levels of risk aversion are sufficiently different. If, however, their risk attitudes are similar, countries opt for shallower trade integration - either a shallow CU or a FTA - if they face low levels of uncertainty, and choose to stand alone if one country faces a sufficiently high level of uncertainty. When countries’ demands are correlated, they tend to form a deep CU if their demands are strongly negatively correlated, a FTA if their demands are strongly positively correlated and a shallow CU when their demands are weakly correlated. Intuitively, differences in country risk attitudes (i.e., their degree of risk aversion) act as an additional source of comparative advantage. Deeper integration - particularly via a CU - permits less risk averse members to essentially export their relative partiality for risk to more risk averse partners, thereby effectively providing the latter with insurance. |
| Keywords: | Trade Agreement, Free Trade Area, Customs Union, Insurance, Uncertainty, Risk Premium. |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:syd:wpaper:2021-04&r= |
| By: | Jan Obloj; Johannes Wiesel |
| Abstract: | We consider the optimal investment and marginal utility pricing problem of a risk averse agent and quantify their exposure to a small amount of model uncertainty. Specifically, we compute explicitly the first-order sensitivity of their value function, optimal investment policy and marginal option prices to model uncertainty. The latter is understood as replacing a baseline model $\mathbb{P}$ with an adverse choice from a small Wasserstein ball around $\mathbb{P}$ in the space of probability measures. Our sensitivities are thus fully non-parametric. We show that the results entangle the baseline model specification and the agent's risk attitudes. The sensitivities can behave in a non-monotone way as a function of the baseline model's Sharpe's ratio, the relative weighting of assets in an agent's portfolio can change and marginal prices can increase when an agent faces model uncertainty. |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.00935&r= |
| By: | Louis R. Eeckhoudt; Roger J. A. Laeven |
| Abstract: | Employing a generalized definition of Pratt (1964) and Arrow's (1965, 1971) probability premium, we introduce a new concept of attitude towards probability. We illustrate in a problem of risk sharing that whether attitude towards probability is a first-order or second-order phenomenon has important economic applications. By developing a local approximation to the probability premium, we show that the canonical rank-dependent utility model usually exhibits attitude towards probability of first order, whereas under the dual theory with smooth probability weighting functions attitude towards probability is a second-order trait. |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.00054&r= |
| By: | Loic Berger (CNRS, IESEG School of Management, Univ. Lille, UMR 9221-LEM, F-59000 Lille, France); Louis Eeckhoudt (IESEG School of Management, UMR 9221-LEM, F-59000 Lille, France) |
| Abstract: | Diversification is a basic economic principle that helps to hedge against uncertainty. It is therefore intuitive that both risk aversion and ambiguity aversion should positively affect the value of diversification. In this paper, we show that this intuition (1) is true for risk aversionbut (2) is not necessarily true for ambiguity aversion. We derive sufficient conditions, showing that, contrary to the economic intuition, ambiguity and ambiguity aversion may actually reduce the diversification value. |
| Keywords: | Diversification, ambiguity aversion, model uncertainty, hedging |
| JEL: | D81 |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:ies:wpaper:e202104&r= |
| By: | Loic Berger (CNRS, IESEG School of Management, Univ. Lille, UMR 9221–LEM, F-59000 Lille, France; and Bocconi University, Italy) |
| Abstract: | This paper reflects on the notion of partial ambiguity. Using a framework de-composing ambiguity into distinct layers of analysis, among which are risk and model uncertainty, and allowing for different attitudes toward these layers, I show that partial ambiguity may prove less desirable thanfull ambiguity, even under ambiguity aversion. This observation poses difficulties for interpreting the notion of partial ambiguity in relation to the partial information available to determine the potential compositions of an ambiguous urn. Two Ellsberg-style thought experiments are described to challenge the meaning of partial ambiguity further, and an alternative interpretation, based on a more ambiguous relation, is discussed. |
| Keywords: | Ambiguity, model uncertainty, smooth ambiguity aversion, Ellsberg para-dox |
| JEL: | D81 |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:ies:wpaper:e202103&r= |
| By: | Farzad Pourbabaee |
| Abstract: | A decision maker's utility depends on her action $a\in A \subset \mathbb{R}^d$ and the payoff relevant state of the world $\theta\in \Theta$. One can define the value of acquiring new information as the difference between the maximum expected utility pre- and post information acquisition. In this paper, I find asymptotic results on the expected value of information as $d \to \infty$, by using tools from the theory of (sub)-Guassian processes and generic chaining. |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.00545&r= |
| By: | Sekar, Shreyas; Vojnovic, Milan; Yun, Se-Young |
| Abstract: | We study the canonical problem of maximizing a stochastic submodular function subject to a cardinality constraint, where the goal is to select a subset from a ground set of items with uncertain individual perfor- mances to maximize their expected group value. Although near-optimal algorithms have been proposed for this problem, practical concerns regarding scalability, compatibility with distributed implementation, and expensive oracle queries persist in large-scale applications. Motivated by online platforms that rely on indi- vidual item scores for content recommendation and team selection, we study a special class of algorithms that select items based solely on individual performance measures known as test scores. The central contribution of this work is a novel and systematic framework for designing test score based algorithms for a broad class of naturally occurring utility functions. We introduce a new scoring mechanism that we refer to as replication test scores and prove that as long as the objective function satisfies a diminishing returns condition, one can leverage these scores to compute solutions that are within a constant factor of the optimum. We then extend these scoring mechanisms to the more general stochastic submodular welfare maximization problem, where the goal is to partition items into groups to maximize the sum of the expected group values. For this more difficult problem, we show that replication test scores can be used to develop an algorithm that approximates the optimum solution up to a logarithmic factor. The techniques presented in this work bridge the gap between the rigorous theoretical work on submodular optimization and simple, scalable heuristics that are useful in certain domains. In particular, our results establish that in many applications involving the selection and assignment of items, one can design algorithms that are intuitive and practically relevant with only a small loss in performance compared to the state-of-the-art approaches. |
| Keywords: | stochastic combinatorial optimization; submodular functions; welfare maximization; Test scores |
| JEL: | C1 |
| Date: | 2020–07–15 |
| URL: | http://d.repec.org/n?u=RePEc:ehl:lserod:103176&r= |
| By: | Vincent Martinet (INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement); Pedro Gajardo; Michel de Lara |
| Abstract: | Applying the solutions defined in the axiomatic bargaining theory to actual bargaining problems is a challenge when the problem is not described by its Utility Possibility Set (UPS) but as an economic environment specifying the set of alternatives and utility profile underlying the UPS. We introduce the axioms of Independence of Non-Efficient Alternatives and Independence of Redundant Alternatives. A solution satisfying these axioms can be applied to a simplified problem based on any reduced set of alternatives generating the Pareto frontier of the initial problem, and produces the same outcome. We compare our axioms to usual independence axioms, and show that they are satisfied by many usual bargaining solutions. Then, we introduce monotonicity conditions corresponding to the existence of an interest group (i.e., agents ranking the alternatives in the same order). For such monotonic economic environments, we provide a parameterized family of alternatives that generates the Pareto frontier of the bargaining problem, in line with our previous results. Our analysis illustrates that an axiomatic approach can be useful to foster the application of bargaining solutions, in complement to usual computational methods. |
| Date: | 2021–04–23 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-03206724&r= |
| By: | Gadenne, Lucie; Norris, Sam; Singhal, Monica; Sukhtankar, Sandip |
| Abstract: | Recent debates about the optimal form of social protection programs have highlighted the potential for cash as the preferred form of transfer to low income households. However, in-kind transfers remain prevalent throughout the world. We argue that beneficiaries themselves may prefer in-kind transfers because these transfers can provide insurance against price risk. Households in developing countries often face substantial price variation as a result of poorly integrated markets. We develop a model demonstrating that in-kind transfers are welfare improving relative to cash if the covariance between the marginal utility of income and price is positive. Using calorie shortfalls as a proxy for marginal utility, we find that in-kind transfers improve welfare relative to cash for Indian households, an effect driven entirely by poor households. We further show that expansions in the generosity of the Public Distribution System (PDS) - India's in-kind food transfer program - result not only in increased caloric intake but also reduced sensitivity of calories to prices. |
| Keywords: | cash transfers; in-kind transfers; India; price risk; Public Distribution System |
| JEL: | H42 H53 I38 O12 Q18 |
| Date: | 2021–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15844&r= |
| By: | Frondel, Manuel; Osberghaus, Daniel; Sommer, Stephan |
| Abstract: | Based on panel data on around 5,500 German households, this paper analyzes whether the experience of financial losses due to the Corona pandemic has affected three kinds of personal traits and preferences: the willingness to take risks, patience, and the locus of control. Our empirical results indicate that patience and the locus of control remain unchanged by the experience of pandemic-related financial losses, whereas we find a significantly negative effect of severe financial losses on risk taking, contrasting with the traditional assumption that such preferences are constant. In this respect, our heterogeneity analysis indicates that financial losses due to Corona particularly affect the most vulnerable households, notably low-income households and those with little income diversification. |
| Keywords: | Patience,risk aversion,locus of control |
| JEL: | D91 C23 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:rwirep:903&r= |
| By: | de la Croix, David; Doepke, Matthias |
| Abstract: | A long-standing challenge for welfare economics is to develop welfare criteria that can be applied to allocations with different population levels. Such a criterion is essential to resolve the optimal population problem, i.e., the tradeoff between population size and the welfare of each person alive. A welfare criterion that speaks to this issue inherently requires evaluating the welfare of nonexistent people, because some people exist only in some allocations but not in others. To make progress, we consider the population problem in an environment where population is variable, but there is a fixed supply of souls, who may experience multiple incarnations over time. Rather than pondering the value of nonexistence, from the souls' perspective comparing larger or smaller populations merely involves valuing shorter or longer waits until the next incarnation. We argue that such comparisons are possible on the basis of introspection and lead to intuitive welfare criteria with attractive properties. We emphasize that one does not have to believe in reincarnation to accept the resulting criteria; rather, reincarnation serves as a metaphor to facilitate the necessary utility comparisons. |
| Keywords: | Endogenous Discounting; Population Ethics; Reincarnation; Repugnant Conclusion; Utilitarianism |
| JEL: | D63 H43 J11 Q56 |
| Date: | 2021–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15911&r= |
| By: | Karle, Heiko; Schumacher, Heiner; Volund, Rune |
| Abstract: | We consider a model of Bertrand competition where consumers are uncertain about the qualities and prices of firms' products. Consumers can inspect all products at zero cost. A share of consumers is expectation-based loss averse. For these consumers, a purchase plan, which involves buying products of varying quality and price with positive probability, creates scale-dependent disutility from gain-loss sensations. Even if their degree of loss aversion is modest, they may refrain from inspecting all products and choose an individual default that is first-order stochastically dominated. Firms' strategic behavior can exacerbate the scope for this "uncertainty effect", and sellers of inferior products may earn positive profits despite Bertrand competition. We find suggestive evidence for the predicted association between consumer behavior and loss aversion in new survey data. |
| Keywords: | Competition; consumer search; loss aversion |
| JEL: | D21 D83 L41 |
| Date: | 2021–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15967&r= |
| By: | Kumar B, Pradeep |
| Abstract: | The New Normal has become a buzzword thank to the Covid-19 pandemic. The realization that the pandemic is to persist has tended people to redesign their livelihood opportunities to realize not only a New Normal but a Better or Different Normal. Behavioral Economics, a new branch in economics that mixes economics with other disciplines in an attempt to present real economic behavior of man, has been found to be relevant in explaining the behavior of economic agents in times of Covid. This paper intends to focus on the certain aspects in behavioral economics which the policy makers find useful to design their strategies in dealing with the spreading of the Covid-19 pandemic. |
| Keywords: | New Normal, Better Normal, Different Normal, Rationality, Present Bias, Status Quo Bias, Optimum Bias, Framing effect, Affect heuristic, Herding Behavior, Infodemic |
| JEL: | I00 |
| Date: | 2020–08–06 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:107502&r= |
| By: | Lionel De Boisdeffre (Centre d'Economie de la Sorbonne) |
| Abstract: | We consider a pure-exchange sequential economy, where uncertainty prevails and agents, possibly asymmetrically informed, exchange commodities, on spot markets, and securities of all kinds, on typically incomplete financial markets. Consumers have private characteristics, anticipations and beliefs, and no model to forecast prices. We show that they face an incompressible uncertainty, represented by a so-calles 'minimum uncertainty set', which adds to the exogenous uncertainty, on the state of nature, an uncertainty over the price to prevail, on every spot market. Equilibrium is reached when agents expect the 'true' price as a possible outcome on every spot market, and elect optimal strategies, which clear on all markets. We show this sequential equilibrium exists in standard conditions, when agents' anticipations embed the minimum uncertainty set. This outcome is stronger than Radner's (1979), Duffie-Shaffer's (1985) or De Boisdeffre's (2021), which prove the generic existence of equilibrium when agents make perfect forecasts. From an asymptotic argument, our main theorem is derived from De Boisdeffre's (2007), which characterizes the exitence of equilibria on purely financial markets by a no-arbitrage condition |
| Keywords: | sequential equilibrium; temporary equilibrium; perfect foresight; existence; rational expectations; financial markets; asymmetric information; arbitrage |
| JEL: | D52 |
| Date: | 2021–02 |
| URL: | http://d.repec.org/n?u=RePEc:mse:cesdoc:21009&r= |
| By: | Sakamoto, Norihito |
| Abstract: | This study shows that combining the Pareto principle and continuity with scale invariance, which has usually been interpreted as the requirement of interpersonal comparisons of well-being, imposes a major constraint on a functional form of a social welfare ordering. In fact, if the social welfare ordering is required to satisfy cardinal full comparability of well-being, then it must belong to a class of weighted utilitarianisms with variable weights. However, thorough an appropriate reformulation on interpersonal comparisons of well-being, the class of acceptable social welfare orderings is shown to be a rank-dependent generalized utilitarianism that can show compassion for both relative inequality and poverty. If additional conditions are required, we can obtain some refinements of this social welfare ordering such as a rank-weighted generalized utilitarianism and a rank-weighted Atkinson-Blackorby-Donaldson social welfare ordering. Moreover, the rank-weighted generalized utilitarianism is shown to approximately include the well-known three social welfare orderings that have been proposed in ethics: the Pareto egalitarianism, prioritarianism, and sufficientarianism. Therefore, it makes clear that the theoretical difference between the ideas of distributive justice in ethical theory is simply caused by intensity levels for tolerable inequality and poverty. These results can be easily extended to the context of social choice with variable populations. |
| JEL: | D63 D71 H43 H51 H52 H53 I14 I24 I31 I32 J18 Q56 |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:hit:rcnedp:9&r= |
| By: | Mohamed Mrad (UP13 - Université Paris 13) |
| Abstract: | The method of characteristics is a powerful tool to solve some nonlinear second order stochastic PDEs like those satisfied by a consistent dynamic utilities, see [EM13, MM20]. In this situation the solution V (t, z) is theoretically of the formX t V (0,ξ t (z)) whereX and Y are solutions of a system of two SDEs,ξ is the inverse flow ofȲ and V (0, .) is the initial condition. Unfortunately this representation is not explicit except in simple cases whereX andȲ are solutions of linear equations. The objective of this work is to take advantage of this representation to establish a numerical scheme approximating the solution V using Euler approximations X N and ξ N of X and ξ. This allows us to avoid a complicated discretizations in time and space of the SPDE for which it seems really difficult to obtain error estimates. We place ourselves in the framework of SDEs driven by Lévy noise and we establish at first a strong convergence result, in L p-norms, of the compound approximation X N t (Y N t (z)) to the compound variable X t (Y t (z)), in terms of the approximations of X and Y which are solutions of two SDEs with jumps. We then apply this result to Utility-SPDEs of HJB type after inverting monotonic stochastic flows. |
| Keywords: | Utility-SPDE,SPDE driven by Lévy noise,method of stochastic characteristics,stochastic flow,Euler scheme,strong approximation,Garsia-Rodemich-Rumsey lemma |
| Date: | 2021–04–28 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-03211171&r= |
| By: | Ariane Dupont Kieffer (PHARE - Pôle d'Histoire de l'Analyse et des Représentations Economiques - UP1 - Université Paris 1 Panthéon-Sorbonne - UPN - Université Paris Nanterre - CNRS - Centre National de la Recherche Scientifique); Sylvie Rivot (BETA - Bureau d'Économie Théorique et Appliquée - UL - Université de Lorraine - UNISTRA - Université de Strasbourg - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement); Jean Loup Madre (AME-DEST - Dynamiques Economiques et Sociales des Transports - Université Gustave Eiffel) |
| Abstract: | The golden age of road demand modeling began in the 1950s and flourished in the 1960s in the face of major road construction needs. These macro-models as well as the econometrics and the data to be processed, were mainly provided by engineers. A division of tasks can be observed between the engineers in charge of estimating the flows within the network, and the transport economists in charge of managing these flows once they are on the road network. Yet the inability to explain their decision-making processes and individual drives gave some room to economists to introduce economic analysis, so as to better understand individual or collective decisions between transport alternatives. Economists, in particular McFadden, began to offer methods to improve the measure of utility linked to transport, and to inform the engineering approach. This paper explores the challenges to the boundaries between economics and engineering in road demand analysis. |
| Keywords: | Modèle 4 étapes,Demande routière,Histoire des modèles de transport,Utilité marginale |
| Date: | 2021–01–01 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-03209945&r= |
| By: | Li, Xiaolin; Özer, Özalp; Subramanian, Upender |
| Abstract: | Cheap-talk communication between parties with conflicting interests is common in many business and economic settings. Two distinct behavioral economics theories, the trust-embedded model and the level-k model, have emerged to explain how cheap talk works between human decision makers. The trust-embedded model considers that decision makers are motivated by nonpecuniary motives to be trusting and trustworthy. In contrast, the level-k model considers that decision makers are purely self-interested but limited in their ability to think strategically. Although both theories have been successful in explaining cheap-talk behaviors in separate contexts, they point to contrasting drivers for human behaviors. In this paper, we provide the first direct comparison of both theories within the same context. We show that, in a cheap-talk setting that well represents many practical situations, the two models make characteristically distinct and empirically distinguishable predictions. We leverage past experiment data from this setting to determine what aspects of cheap-talk behavior each model captures well and which model (or combination of models) has better explanatory power and predictive performance. We find that the trust-embedded model emerges as the dominant explanation. Our results, thus, highlight the importance of investing in systems and processes to foster trusting and trustworthy relationships in order to facilitate more effective cheap-talk interactions. |
| Keywords: | behavioral economics; bounded rationality; cheap talk; level-k thinking; trust; trustworthiness |
| JEL: | J50 |
| Date: | 2021–03–22 |
| URL: | http://d.repec.org/n?u=RePEc:ehl:lserod:107103&r= |
| By: | Mohsen Foroughifar |
| Abstract: | Individuals often interact with each other through observation -- they observe the choices of other people who possess private information. In such social interactions, it is typically assumed that decision makers have rational expectations, therefore they can infer what other decision makers know via observation of their choices. In this study, I assess the validity of the rational expectations assumption in a social interaction experiment. I use a simple and transparent experimental setting to show that decision makers often fail to exhibit rational expectations in social interactions and this behavior is independent of commonly documented errors in statistical reasoning: subjects exhibit a higher level of irrationality in the presence than in the absence of social interaction, even when they receive informationally equivalent signals across the two conditions. A series of treatments aimed at identifying mechanisms suggests that the behavior of other people are often "ambiguous" to a decision maker who observes their choices. So, the decision maker behaves as if she has limited ability to infer the relationship between what other people choose and what they know. |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.01043&r= |
| By: | Antler, Yair; Arad, Ayala |
| Abstract: | We experimentally examine how individuals stop risky processes such as the evolution of prices when they have commitment power. We find types who consistently choose stopping rules with large potential losses and small potential gains to induce a high winning probability (L-types), although such choices entail a considerable downside risk. A smaller proportion of types choose stopping rules with the opposite characteristics. While the latter pattern is consistent with cumulative prospect theory, the former pattern is inconsistent with prominent decision theories. We suggest that L-types solve the prize-probability tradeoff in a qualitative manner, putting more emphasis on the winning probability. |
| Keywords: | commitment; risky processes; stopping problems; type classification |
| Date: | 2021–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15973&r= |
| By: | Bloom, David; Ferranna, Maddalena; Sevilla, JP |
| Abstract: | The COVID-19 pandemic has forced countries to make difficult ethical choices, e.g., how to balance public health and socioeconomic activity and whom to prioritize in allocating vaccines or other scarce medical resources. We discuss the implications of benefit-cost analysis, utilitarianism, and prioritarianism in evaluating COVID-19-related policies. The relative regressivity of COVID-19 burdens and control policy costs determines whether increased sensitivity to distribution supports more or less aggressive control policies. Utilitarianism and prioritarianism, in that order, increasingly favor income redistribution mechanisms compared with benefit-cost analysis. The concern for the worse-off implies that prioritarianism is more likely than utilitarianism or benefit-cost analysis to target young and socioeconomically disadvantaged individuals in the allocation of scarce vaccine doses. |
| Keywords: | benefit-cost analysis; control policies; COVID-19; lockdown; prioritarianism; Utilitarianism; vaccine allocation |
| JEL: | D6 I1 I3 |
| Date: | 2021–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15904&r= |
| By: | Kazi Iqbal; Asadul Islam; John A. List; Vy Nguyen |
| Abstract: | Whether, and to what extent, behavioral anomalies uncovered in the lab manifest themselves in the field remains of first order importance in finance and economics. We begin by examining behavior of retail traders/investors making investment decisions in constructed laboratory markets. Our results show that the behaviors of the traders are consistent with myopic loss aversion. We combine the lab results with a unique individual-level matched dataset on daily stock market transactions and portfolio positions over a two year period. We find that lab behaviors help to predict, but do not fully capture, the essential real-world trading analogs of retail traders. |
| JEL: | C9 C93 D03 N97 |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:28730&r= |