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on Utility Models and Prospect Theory |
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Issue of 2021‒07‒19
seventeen papers chosen by |
| By: | David Hobson; Martin Herdegen; Joseph Jerome |
| Abstract: | In this article we consider the optimal investment-consumption problem for an agent with preferences governed by Epstein-Zin stochastic differential utility who invests in a constant-parameter Black-Scholes-Merton market. The paper has three main goals: first, to provide a detailed introduction to infinite-horizon Epstein-Zin stochastic differential utility, including a discussion of which parameter combinations lead to a well-formulated problem; second, to prove existence and uniqueness of infinite horizon Epstein-Zin stochastic differential utility under a restriction on the parameters governing the agent's risk aversion and temporal variance aversion; and third, to provide a verification argument for the candidate optimal solution to the investment-consumption problem among all admissible consumption streams. To achieve these goals, we introduce a slightly different formulation of Epstein-Zin stochastic differential utility to that which is traditionally used in the literature. This formulation highlights the necessity and appropriateness of certain restrictions on the parameters governing the stochastic differential utility function. |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2107.06593&r= |
| By: | Philipp Strack; Dmitry Taubinsky |
| Abstract: | We study identification of time inconsistency when an agent at time 0 makes an advance commitment, and later at time 1 can revise their choice after possibly receiving additional information. Roughly speaking, we prove that the only data that reject time-consistent expected utility maximization is a time-0 choice that is always strictly dominated at time 1. This holds for rich choice sets; if the complete ranking of alternatives is observed in every period and state; when it is natural to assume additional properties like concavity; and with supplementary cardinal information. However, time inconsistency can be point identified from willingness to pay for different alternatives in both periods, if utility from money is plausibly additively-separable and independent of time-1 information. |
| JEL: | C9 D0 D9 |
| Date: | 2021–06 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:28961&r= |
| By: | Knut Anton Mork (Department of Economics, Norwegian University of Science and Technology); Vegard Skonseng Bjerketvedt (Department of Industrial Economics and Technology Management, Norwegian University of Science and Technology) |
| Abstract: | Models of habit formation in consumption typically specify utility over the excess of consumption above some habit level. This specification is unsatisfactory in settings where agents occasionally have to tolerate consumption below the habit level. More importantly, they often imply infeasible solutions with realistically low riskless rates. We propose an alternative specification, where the curvature of the utility function rises steeply for consumption below the habit level, but without utility falling abruptly to minus infinity. We explore analytically the key features of the implied behavior and present representative numerical solutions of the model in continuous time. We then simulate investor-consumer behavior with these preferences and compare this behavior to simpler rules of thumb. We find that soft habits, like hard habits, imply procyclical risk taking. Soft habits also allow some smoothing, especially in the downward direction. However, its most distinguishing feature takes the form of deliberate efforts to build sufficient capital to limit the probability of consumption having to fall below habits. Because the priority given to the buildup of wealth, the question of smoothing remains mostly moot in practice. The simpler rules of thumb tend to smooth more and save less that the base case and thus lead to insufficient buildup of capital over time. Of the simpler rules, the relatively best result is found for behavior as if preferences were CRRA with risk aversion somewhere between the soft-habit risk aversion for consumption above and below the habit level. |
| Keywords: | Habit formation; Withdrawal smoothing; Risk taking; Long-term fund-preservation |
| JEL: | C63 E21 G11 |
| Date: | 2021–06–29 |
| URL: | http://d.repec.org/n?u=RePEc:nst:samfok:18921&r= |
| By: | Patrick Reinwald; Stephan Leitner; Friederike Wall |
| Abstract: | Models of economic decision makers often include idealized assumptions, such as rationality, perfect foresight, and access to all relevant pieces of information. These assumptions often assure the models' internal validity, but, at the same time, might limit the models' power to explain empirical phenomena. This paper is particularly concerned with the model of the hidden action problem, which proposes an optimal performance-based sharing rule for situations in which a principal assigns a task to an agent, and the action taken to carry out this task is not observable by the principal. We follow the agentization approach and introduce an agent-based version of the hidden action problem, in which some of the idealized assumptions about the principal and the agent are relaxed so that they only have limited information access, are endowed with the ability to gain information, and store it in and retrieve it from their (limited) memory. We follow an evolutionary approach and analyze how the principal's and the agent's decisions affect the sharing rule, task performance, and their utility over time. The results indicate that the optimal sharing rule does not emerge. The principal's utility is relatively robust to variations in intelligence, while the agent's utility is highly sensitive to limitations in intelligence. The principal's behavior appears to be driven by opportunism, as she withholds a premium from the agent to assure the optimal utility for herself. |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2107.03764&r= |
| By: | Mikhail Pakhnin |
| Abstract: | This paper reviews recent research on the aggregation of heterogeneous time preferences. Main results are illustrated in simple Ramsey models with two or three agents who differ in their discount factors. We employ an intertemporal view on these models and argue that preferences of a decision maker should be represented by a sequence of utility functions. This allows us to clarify the issue of dynamic inconsistency and relate it to simple properties of discounting. We distinguish between private and common consumption cases. In the private consumption case, we discuss the properties of sequences of Paretian social welfare functions and explain why the notion of Pareto optimality under heterogeneous time preferences becomes problematic. In the common consumption case, we focus on the problem of collective choice under heterogeneous time preferences, discuss the difficulties with dynamic voting procedures and review some ways to overcome them. We conclude by highlighting the implications of our discussion for the problem of choosing an appropriate social discount rate. |
| Keywords: | collective decisions, social welfare function, heterogeneous agents, time consistency, voting, social discount rate |
| JEL: | D15 D71 H43 O40 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_9141&r= |
| By: | Spears, Dean (University of Texas at Austin); Zuber, Stéphane (Paris School of Economics) |
| Abstract: | Utilitarianism is the most prominent family of social welfare functions. We present three new axiomatic characterizations of utilitarian (that is, additively separable) social welfare functions in a setting where there is risk over both population size and the welfares of individuals. First, we show that, given uncontroversial basic axioms, Blackorby et al.'s (1998) Expected Critical-Level Generalized Utilitarianism (ECLGU) is equivalent to a new axiom holding that it is better to allocate higher utility-conditional-on-existence to possible people who have a higher probability of existence. The other two novel characterizations extend classic axiomatizations of utilitarianism from settings with either social risk or variable-population, considered alone. By considering both social risk and variable population together, we clarify the fundamental normative considerations underlying utilitarian policy evaluation. |
| Keywords: | expected critical-level generalized utilitarianism, utilitarianism, population ethics, social risk, prioritarianism |
| JEL: | D63 D81 J10 |
| Date: | 2021–06 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp14515&r= |
| By: | Jean-Pierre Fouque; Ruimeng Hu; Ronnie Sircar |
| Abstract: | The problem of portfolio optimization when stochastic factors drive returns and volatilities has been studied in previous works by the authors. In particular, they proposed asymptotic approximations for value functions and optimal strategies in the regime where these factors are running on both slow and fast timescales. However, the rigorous justification of the accuracy of these approximations has been limited to power utilities and a single factor. In this paper, we provide an accuracy analysis for cases with general utility functions and two timescale factors by constructing sub- and super-solutions to the fully nonlinear problem such that their difference is at the desired level of accuracy. This approach will be valuable in various related stochastic control problems. |
| Date: | 2021–06 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2106.11510&r= |
| By: | Xiaoyu Cheng |
| Abstract: | This note shows that the value of ambiguous persuasion characterized in Beauchene, Li and Li(2019) can be given by a concavification program as in Bayesian persuasion (Kamenica and Gentzkow, 2011). More specifically, it implies that an ambiguous persuasion game can be equivalently formalized as a Bayesian persuasion game with distorted utility functions. This result is obtained under a novel construction of ambiguous persuasion. |
| Date: | 2021–06 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2106.11270&r= |
| By: | Kwadwo Osei Bonsu |
| Abstract: | In a legal dispute, parties engage in a series of negotiations so as to arrive at a reasonable settlement. The parties need to present a fair and reasonable bargain in order to induce the WTA, willingness to accept of the plaintiff and the WTP, willingness to pay of the defendant. Cooperation can only be attained when the WTA of the plaintiff is less than or equal to the WTP of the defendant. From an economic perspective, the legal process can considered as market place of buying and selling claims. High transaction costs decrease the reasonable bargain, thereby making cooperation more appealing to the defendant. On the other hand, low or zero transaction costs means the reasonable bargain is only dependent on the expected gain from winning at trial and the settlement benefit thereby making cooperation more appealing to the plaintiff. Hence, we need to find a way of adjusting the number of settlements with the number of trials in order to maximize the social utility value. This paper uses Cobb-Douglas optimization to formulate an optimal transaction cost algorithm considering the confinement of a generalized legal framework. |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2107.07168&r= |
| By: | Maximilian Blesch (Berlin School of Economics); Philipp Eisenhauer (University of Bonn) |
| Abstract: | Economists often estimate a subset of their model parameters outside the model and let the decision-makers inside the model treat these point estimates as-if they are correct. This practice ignores model ambiguity, opens the door for misspecification of the decision problem, and leads to post-decision disappointment. We develop a framework to explore, evaluate, and optimize decision rules that explicitly account for the uncertainty in the first step estimation using statistical decision theory. We show how to operationalize our analysis by studying a stochastic dynamic investment model where the decision-makers take ambiguity about the model's transition dynamics directly into account. |
| Keywords: | decision-making under uncertainty, robust Markov decision process |
| JEL: | D81 C44 D25 |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:ajk:ajkdps:104&r= |
| By: | Erik Eyster; Shengwu Li; Sarah Ridout |
| Abstract: | Human beings attempt to rationalize their past choices, even those that were mistakes in hindsight. We propose a formal theory of this behavior. The theory predicts that agents commit the sunk-cost fallacy. Its model primitives are identified by choice behavior and it yields tractable comparative statics. |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2107.07491&r= |
| By: | Massimo D'Antoni; Ugo Pagano |
| Abstract: | Even in the most advanced societies, individuals seem to live in mutually exclusive social and economic spheres. During their leisure time, there is an increasing supply of all sorts of goods that should allow all sorts of happy activities. During their work time they feel used as increasingly flexible means of production. Institutions, which include consumption, are often excluding production. Institutions, which include production, are often excluding consumption. Standard economic theory has become a powerful ideology justifying this divide. The paper challenges this ideology and proposes a more general approach where in principle all human activities can contribute to final utility as well as to production. Our approach can give a rationale for policies favoring inclusive institutions that try to overcome the work-leisure divide and allow us to move towards a more satisfactory structure of human activitie |
| Keywords: | work, leisure, economic ideology, institutions of capitalism |
| JEL: | J18 I31 D13 L21 |
| Date: | 2021–03 |
| URL: | http://d.repec.org/n?u=RePEc:usi:wpaper:852&r= |
| By: | Benoit Chèze (IFPEN - IFP Energies nouvelles - IFPEN - IFP Energies nouvelles, EconomiX-CNRS, University of Paris); Charles Collet (CIRED-CNRS); Anthony Paris (EconomiX-CNRS, University of Paris, LEO - Laboratoire d'Économie d'Orleans - UO - Université d'Orléans - Université de Tours - CNRS - Centre National de la Recherche Scientifique) |
| Abstract: | This working paper overviews theoretical foundations and estimators derived from econometric models used to analyze stated choices proposed in Discrete Choice Experiment (DCE)surveys. Discrete Choice Modelling is adapted to the case where the variable to be explained is a qualitative variable which cannot be ranked in relation to each other. A situation which occurs in many cases in everyday life as people often have to choose only one alternative among a proposed set of different ones in many fields (early in the morning, just think about how you pick clothes for instance). DCE is a Stated Preference method in which preferences are elicited through repeated fictional choices, proposed to a sample of respondents. Compared to Revealed Preference methods, DCEs allow for an ex ante evaluation of public policies that do not yet exists. |
| Keywords: | Revealed preference theory,Stated Preference / Stated Choice methods,Discrete Choice Modelling,Discrete Choice Experiment |
| Date: | 2021–04–12 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-03262187&r= |
| By: | Michael Crystal |
| Abstract: | We present a framework for analyzing the near miss effect in lotteries. A decision maker (DM) facing a lottery, falsely interprets losing outcomes that are close to winning ones, as a sign that success is within reach. As a result of this false belief, the DM will prefer lotteries that induce a higher frequency of near misses, even if the underlying probability of winning is constant. We define a near miss index that measures the near miss effect induced by a given lottery and analyze the optimal lottery design in terms of near miss. This analysis leads us to establish a fruitful connection between our near miss framework and the field of coding theory. Building on this connection we compare different lottery frames and the near miss effect they induce. Analyzing an interaction between a seller and a buyer of lotteries allows us to gain further insight into the optimal framing of lotteries and might offer a potential explanation as to why lotteries with a very small probability of winning are commonplace and attractive. |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2107.02478&r= |
| By: | Yannick Hoga; Timo Dimitriadis |
| Abstract: | Loss functions are widely used to compare several competing forecasts. However, forecast comparisons are often based on mismeasured proxy variables for the true target. We introduce the concept of exact robustness to measurement error for loss functions and fully characterize this class of loss functions as the Bregman class. For such exactly robust loss functions, forecast loss differences are on average unaffected by the use of proxy variables and, thus, inference on conditional predictive ability can be carried out as usual. Moreover, we show that more precise proxies give predictive ability tests higher power in discriminating between competing forecasts. Simulations illustrate the different behavior of exactly robust and non-robust loss functions. An empirical application to US GDP growth rates demonstrates that it is easier to discriminate between forecasts issued at different horizons if a better proxy for GDP growth is used. |
| Date: | 2021–06 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2106.11104&r= |
| By: | Spash, Clive L.; Smith, Tone |
| Abstract: | The values of Nature are today ever more contested in attempts to reduce them to a narroweconomics calculus and financial metrics. The crisis of modernity is evident is that the concept ofNature itself has been subject to post-modern deconstruction as archaic Romanticism whilesimultaneously being made into a modernist capital form by economists, bankers and financiers. Inthis paper we start by defining the meaning of Nature before moving to its values, the two beinginseparable. Nature is seen as combining three aspect: (i) being ‘other’ than human, (ii) abiophysical structure and (iii) a quality which humans commonly and intuitively reference butstruggle to specify. When turning to the values of Nature we describe the three major meta-ethicalsystems of Western philosophy—utilitarianism, deontology and virtue ethics. The contestationespecially between utilitarian and rights-based approaches is explored. The role of intrinsic value inthese systems is outlined. Modern mainstream economic valuation is then placed in context of theforgoing discussion and critically reviewed as a misguided but hegemonic approach to valuingNature. The terrain of debate is laid out, briefly covering recent developments of rights to Natureand Nature’s contribution to people. That Nature cannot be dismissed as a concept (somethingattempted by some post-modernists and strong constructionists), but remains importantly contestedin terms of its values, is central to understanding the on-going social-ecological conflicts created by. |
| Keywords: | environmental values, Nature, ethics, utilitarianism, rights, virtue, incommensurability,intrinsic value, economic valuation, moral considerability; standing, plural values |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:wiw:wus009:8176&r= |
| By: | Armin Falk (briq and the University of Bonn); Thomas Neuber (University of Bonn); Philipp Strack (Yale University) |
| Abstract: | We study response behavior in surveys and show how the explanatory power of self-reports can be improved. First, we develop a choice model of survey response behavior under the assumption that the respondent has imperfect self-knowledge about her individual characteristics. In panel data, the model predicts that the variance in responses for different characteristics increases in self-knowledge and that the variance for a given characteristic over time is non-monotonic in self-knowledge. Importantly, the ratio of these variances identifies an individual's level of self-knowledge, i.e. the latter can be inferred from observed response patterns. Second, we develop a consistent and unbiased estimator for self-knowledge based on the model. Third, we run an experiment to test the model's main predictions in a context where the researcher knows the true underlying characteristics. The data confirm the model's predictions as well as the estimator's validity. Finally, we turn to a large panel data set, estimate individual levels of self-knowledge, and show that accounting for differences in self-knowledge significantly increases the explanatory power of regression models. Using a median split in self-knowledge and regressing risky behaviors on self-reported risk attitudes, we find that the R2 can be multiple times larger for above- than below-median subjects. Similarly, gender differences in risk attitudes are considerably larger when restricting samples to subjects with high self-knowledge. These examples illustrate how using the estimator may improve inference from survey data. |
| Keywords: | survey research, rational inattention, laboratory experiments, non-cognitive skills, preferences |
| JEL: | C83 D91 J24 |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:hka:wpaper:2021-035&r= |