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on Utility Models and Prospect Theory |
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Issue of 2021‒08‒16
seventeen papers chosen by |
| By: | Giuseppe Ferro (ETH Zürich - Department of Management, Technology, and Economics (D-MTEC)); Tatyana Kovalenko (ETH Zurich); Didier Sornette (ETH Zürich - Department of Management, Technology, and Economics (D-MTEC); Swiss Finance Institute; Southern University of Science and Technology; Tokyo Institute of Technology) |
| Abstract: | We propose a new parametrization of Quantum Decision Theory (QDT), based on Rank Dependent Utility Theory (RDU). Using experimental data made of choices between pairs of lotteries, we compare QDT with "classical" decision theories, RDU and Cumulative Prospect Theory (CPT). At the aggregate level, calibrating together all decisions performed by all subjects (representative agent approach), we find that CPT-based QDT outperforms, with the quantum models always improving their classical counterpart. At the individual level, adopting a hierarchical maximum likelihood estimation to avoid overfitting, we classify decision makers as either RDU, RDU-based QDT, CPT or CPT-based QDT. Our major findings are the following: the quantum attraction factor plays a key role in describing subjects’ behaviors; there is a considerable heterogeneity across subjects, at odds with the representative agent approach; RDU and RDU-based QDT describe a larger fraction of subjects than CPT and CPT-based QDT, again at odds with the conclusion using the representative agent approach; a temporal stability of asset integration attitudes is found for a good fraction of the subjects; another significant fraction of subjects may be using mixtures of mental models, which are elicited selectively depending on the nature of the presented choice alternatives. |
| Keywords: | choice under risk, quantum decision theory, rank-dependent utility theory, cumulative prospect theory |
| JEL: | A12 C44 D81 |
| Date: | 2021–01 |
| URL: | http://d.repec.org/n?u=RePEc:chf:rpseri:rp2149&r= |
| By: | Ali al-Nowaihi; Sanjit Dhami |
| Abstract: | We formulate a general theory of preferences over outcome-time-probability triplets and decompose uncertainty into risk and hazard. We define the delay, defer, shift and certainty functions that can be uniquely elicited from behaviour. These individually determine stationarity, the common difference effect and its converse; constant, decreasing and increasing impatience; additivity, subadditivity and super additivity; probability independence, the certainty effect and its converse. We propose a general discounted utility model which encompasses the main empirically supported discounted utility models. We show that our axioms on preferences are satisfied in our general discounted utility model. Finally, we discuss the various explanations of the common difference effect. |
| Keywords: | time preferences, preferences under uncertainty, discounted utility models, common difference effect, impatience, additivity, certainty effect, probability weighting function, survival function |
| JEL: | D15 D91 D81 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_9215&r= |
| By: | Xun Li; Xiang Yu; Qinyi Zhang |
| Abstract: | This paper studies an optimal consumption problem for a loss-averse agent with reference to past consumption maximum. To account for loss aversion on relative consumption, an S-shaped utility is adopted that measures the difference between the non-negative consumption rate and a fraction of the historical spending peak. We consider the concave envelope of the realization utility with respect to consumption, allowing us to focus on an auxiliary HJB variational inequality on the strength of concavification principle and dynamic programming arguments. By applying the dual transform and smooth-fit conditions, the auxiliary HJB variational inequality is solved in closed-form piecewisely and some thresholds of the wealth variable are obtained. The optimal consumption and investment control of the original problem can be derived analytically in the piecewise feedback form. The rigorous verification proofs on optimality and concavification principle are provided. |
| Date: | 2021–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2108.02648&r= |
| By: | Pashchenko, Svetlana; Porapakkarm, Ponpoje |
| Abstract: | How does the value of life affect annuity demand? To address this question, we construct a portfolio choice problem with three key features: i) agents have access to life-contingent assets, ii) they always prefer living to dying, iii) agents have non-expected utility preferences. We show that as utility from being alive increases, annuity demand decreases (increases) if agents are more (less) averse to risk rather than to intertemporal fluctuations. Put differently, if people prefer early resolution of uncertainty, they are less interested in annuities when the value of life is high. Our findings have two important implications. First, we get better understanding of the well-known annuity puzzle. Second, we argue that the observed low annuity demand provides evidence that people prefer early rather than late resolution of uncertainty. |
| Keywords: | annuities, value of a statistical life, portfolio choice problem, life-contingent assets, longevity insurance |
| JEL: | D91 G11 G22 |
| Date: | 2021–04–15 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:108886&r= |
| By: | Marc Fleurbaey (PSE - Paris School of Economics - ENPC - École des Ponts ParisTech - ENS Paris - École normale supérieure - Paris - PSL - Université Paris sciences et lettres - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique - EHESS - École des hautes études en sciences sociales - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, CNRS - Centre National de la Recherche Scientifique); Stéphane Zuber (PSE - Paris School of Economics - ENPC - École des Ponts ParisTech - ENS Paris - École normale supérieure - Paris - PSL - Université Paris sciences et lettres - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique - EHESS - École des hautes études en sciences sociales - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, CNRS - Centre National de la Recherche Scientifique, CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique) |
| Abstract: | How to evaluate and compare social prospects when there may be a risk on i) the actual allocation people will receive; ii) the existence of these future people; and iii) their preferences? This paper investigate this question that may arise when considering policies that endogenously affect future people, for instance climate policy. We show that there is no social ordering that meets minimal requirements of fairness, social rationality, and respect for people's ex ante preferences. We explore three ways to avoid this impossibility. First, if we drop the ex ante Pareto requirement, we can obtain fair ex post criteria that take an (arbitrary) expected utility of an equally-distributed equivalent level of well-being. Second, if the social ordering is not an expected utility, we can obtain fair ex ante criteria that assess uncertain individual prospects with a certainty-equivalent measure of well-being. Third, if we accept that interpersonal comparisons rely on VNM utility functions even in absence of risk, we can construct expected utility social orderings that satisfy of some version of Pareto ex ante. |
| Keywords: | Fairness,social risk,intergenerational equity |
| Date: | 2021–06 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:halshs-03289160&r= |
| By: | Andrea Bergesio (University of Zurich - Department of Banking and Finance; Swiss Finance Institute); Pablo Koch-Medina (University of Zurich - Department of Banking and Finance; Swiss Finance Institute); Cosimo Munari (University of Zurich - Department of Banking and Finance; Swiss Finance Institute) |
| Abstract: | Within the context of expected utility and in a discrete loss setting, we provide a complete account of the demand for insurance by strictly-risk averse agents and risk-neutral firms when they enjoy limited liability. When exposed to a bankrupting, binary loss and under actuarially fair prices, individuals and firms will either fully insure or not insure at all. The decision to insure will depend on whether the benefits the insuree derives from insurance after having compensated the damaged party are sufficiently attractive to justify the premium paid. When the loss is nonbinary, even when prices are actuarially fair, any amount of coinsurance can be optimal depending on the nature of the loss. |
| Keywords: | insurance, risk-averse agent, risk-neutral firm, franchise value, limited liability |
| JEL: | D21 D81 G22 G32 G33 |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:chf:rpseri:rp2157&r= |
| By: | Fang Liu |
| Abstract: | It is common to encounter the situation with uncertainty for decision makers (DMs) in dealing with a complex decision making problem. The existing evidence shows that people usually fear the extreme uncertainty named as the unknown. This paper reports the modified version of the typical regret theory by considering the fear experienced by DMs for the unknown. Based on the responses of undergraduate students to the hypothetical choice problems with an unknown outcome, some experimental evidences are observed and analyzed. The framework of the modified regret theory is established by considering the effects of an unknown outcome. A fear function is equipped and some implications are proved. The behavioral foundation of the modified regret theory is further developed by modifying the axiomatic properties of the existing one as those based on the utility function; and it is recalled as the utility-based behavioral foundation for convenience. The application to the medical decision making with an unknown risk is studied and the effects of the fear function are investigated. The observations reveal that the existence of an unknown outcome could enhance, impede or reverse the preference relation of people in a choice problem, which can be predicted by the developed regret theory. |
| Date: | 2021–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2108.01825&r= |
| By: | Haering, Alexander |
| Abstract: | In this study I analyze how lottery framing and lottery display type affect the degree of higher-order risk preferences. I explore differences by comparing reduced and compound lottery framing, and by comparing lotteries in an urn-style and in a spinner-style display format. Overall, my findings show that individual behavior is influenced by lottery framing but not by display format. |
| Keywords: | Risk aversion,prudence,temperance,higher-order risk preferences,lottery framing |
| JEL: | C91 D81 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:rwirep:913&r= |
| By: | Andersen, Torben M.; Bhattacharya, Joydeep; Liu, Qing |
| Abstract: | The classic Aaron–Samuelson result argues that pay-as-you-go (PAYG) pension schemes cannot coexist with higher-return, private, retirement-saving schemes. The ensuing literature shows if agents voluntarily undersave for retirement due to myopia or time-inconsistency, then a paternalistic, rationale for PAYG pensions arises only if voluntary retirement saving is fully crowded out because of a binding borrowing constraint. This paper generalizes the discussion to the reference-dependent utility setup of Kőszegi and Rabin (2009) where undersaving happens naturally. No borrowing constraint is imposed. We show it is possible to offer a non-paternalistic, welfare rationale for return-dominated, PAYG pensions to coexist with private, retirement saving. |
| Date: | 2021–07–01 |
| URL: | http://d.repec.org/n?u=RePEc:isu:genstf:202107010700001813&r= |
| By: | Dean Spears (University of Texas at Austin [Austin], Indian Statistical Institute [New Delhi], IZA - Forschungsinstitut zur Zukunft der Arbeit - Institute of Labor Economics, IFFS - Institute for Futures Studies); Stéphane Zuber (PSE - Paris School of Economics - ENPC - École des Ponts ParisTech - ENS Paris - École normale supérieure - Paris - PSL - Université Paris sciences et lettres - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique - EHESS - École des hautes études en sciences sociales - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, CNRS - Centre National de la Recherche Scientifique, CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique) |
| 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: | Social risk,population ethics,utilitarianism,expected critical-level generalized utilitarianism,prioritarianism |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:halshs-03287583&r= |
| By: | David Pérez-Castrillo; Chaoran Sun |
| Abstract: | We define the proportional ordinal Shapley (the POSh) solution, an ordinal concept for pure exchange economies in the spirit of the Shapley value. Our construction is inspired by Hart and Mas-Colell's (1989) characterization of the Shapley value with the aid of a potential function. The POSh exists and is unique and essentially single-valued for a fairly general class of economies. It satisfies individual rationality, anonymity, and properties similar to the null-player and null-player out properties in transferable utility games. Moreover, the POSh is immune to agents' manipulation of their initial endowments: It is not D-manipulable and does not suffer from the transfer paradox. Finally, we construct a bidding mechanism à la Pérez-Castrillo and Wettstein (2001) that implements the POSh in subgame perfect Nash equilibrium for economies where agents have homothetic preferences and positive endowments. |
| Keywords: | shapley value, exchange economy, ordinal solution, potential, Implementation |
| JEL: | D63 D50 C72 |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:bge:wpaper:1274&r= |
| By: | Svenn Jensen; Christian P. Traeger; Christian Träger |
| Abstract: | Anthropogenic greenhouse gas emissions are changing the energy balance of our planet. Various climatic feedbacks make the resulting warming over the next decades and centuries highly uncertain. We quantify how this uncertainty changes the optimal carbon tax in a stochastic dynamic programming implementation of an integrated assessment model of climate change. We derive a general analytic formula for the “risk premium” governing the resulting climate policy. The formula generalizes simple precautionary savings analysis to more complex economic interactions and it builds the economic intuition for policy making under uncertainty. It clarifies the distinct roles of risk aversion, prudence, characteristics of the damage formulation, and future policy response. We show that an optimal response to uncertainty substantially reduces the risk premium. |
| Keywords: | climate change, uncertainty, risk premium, precautionary savings, prudence, climate policy, dynamic programming, integrated assessment, DICE, recursive utility |
| JEL: | Q54 Q00 D90 C63 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_9196&r= |
| By: | Kyle Greenberg; Michael Greenstone; Stephen P. Ryan; Michael Yankovich |
| Abstract: | This paper estimates the value of a statistical life (VSL), or the willingness to trade-off wealth and mortality risk, among 430,000 U.S. Army soldiers choosing whether to reenlist between 2002 and 2010. Using a discrete choice random utility approach and significant variation in retention bonuses and mortality risk, we recover average VSL estimates that range between $500,000 and $900,000, an order of magnitude smaller than U.S. civilian labor market estimates. Additionally, we fulfill Rosen's (1974) vision to recover indifference curves between wealth and non-market goods (e.g., mortality risk) and document substantial heterogeneity in preferences across types. We find that the VSL increases rapidly with mortality risk within type, and that soldiers in combat occupations have much lower VSLs than those in noncombat occupations. We estimate that the quadrupling of mortality risk from the Afghanistan and Iraq wars reduced annual welfare by $2,355 per soldier, roughly 8 percent of pay. |
| JEL: | J17 J31 J45 |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:29104&r= |
| By: | Davi B. Costa |
| Abstract: | We propose and investigate a model for dating and marriage in large societies based on a stochastic matching process and simple decision rules. Agents have preferences among themselves given by some probability distribution. They randomly search for better mates, forming new couples and breaking apart in the process. Marriage is implemented in the model by adding the decision of stopping searching for a better mate when an agent finds another one with an affinity higher than a certain fixed amount. We show that the average utility in the system with marriage can be higher than in the system without it. Part of our results can be summarized in what sounds like a piece of advice: don't marry the first person you like and don't search for the love of your life, but get married if you like your partner more than a sigma above average. We also compare the evolution of the fraction of married couples in our model with real data and obtain good agreement. In the last section, we formulate the model in the limit of an infinite number of agents and find an analytical expression for the evolution of the system. |
| Date: | 2021–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2108.04885&r= |
| By: | Francesco Vigliarolo (Catholic University of La Plata, National University of La Plata, University of Buenos Aires [Argentina]) |
| Abstract: | The objective of this article is to propose what can be called a law of ontological reason in economics as opposed to the law of supply and demand. To do this, it uses a phenomenological approach that interprets economics in terms of primary ideas. To this end, it's defined the ontological reason and the space in which it is built in order to introduce the concept of demand of rights and not of consumption. In this context, the relationship that underlies an ontological reason which presupposes a different behavior from that of the law of supply and demand is then described. According to this approach, it is claimed that the latter leads to structural problems. It subordinates the general identity of a country to the interests of individuals, as it focuses on maximizing personal utility that is unrelated to the creation of the rights of men and women living in a context that contains them in a relational way. |
| Keywords: | economics,ontology,phenomenology,demand for rights |
| Date: | 2020–12–30 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-03298795&r= |
| By: | Faria, Joao Ricardo; McAdam, Peter; Viscolani, Bruno |
| Abstract: | We study the interaction between monetary and fiscal policies in a Ramsey-Sidrauski model augmented with environmental capital. Equilibrium solutions are studied through the “Green Golden Rule”. Despite the non-separability of money in utility and intertemporally non-separable preferences, money is environmentally neutral. Policy impacts the environment via the marginal rate of transformation rather than the marginal rate of substitution between consumption and environment. Fiscal policies, lump sum and distortionary, under a balanced budget, are also environmentally non-neutral. Only under a non-balanced budget, when deficits are monetized, is money environmentally non-neutral. In alternative approaches (Cash-in-Advance, Transactions Costs), money is environmentally non-neutral. JEL Classification: E52, E62, H23 |
| Keywords: | cash in advance, Chichilnisky et al. conjecture, environmental capital, Friedman rule, green golden rule, Ramsey-Sidrauski, transactions costs |
| Date: | 2021–07 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20212573&r= |
| By: | Heidt, Margareta |
| Abstract: | Digital transformation has established itself as an omnipresent term in the new millennium. Often considered synonymous with the so-called Fourth Industrial Revolution, the term describes the convergence of information technology and the ubiquity of data in private life as well as in business and social lives. Inherent to the term "revolution" is radical change and the upheaval of existing processes and relationships. Translated into a business context, revolution leads to the transformation of business models and established work processes as well as the increasing dependence on data and new technologies. In times of digital transformation, managers and organizational decision-makers are faced with constant, potentially business-critical, decisions regarding these new technologies and the maintenance of information and data security. The analysis of management decisions, therefore, plays a crucial role in comprehending and researching digital transformation. This dissertation, therefore, seeks to improve our understanding of decision-making processes regarding the adoption of cloud computing solutions and data protection measures as well as investments in information technology (IT) security in primarily small and medium-sized enterprises. Article A examines the influence of status quo bias and reference dependency in the decision to adopt cloud computing solutions. Based on the tenets of prospect theory, findings suggest that rather inexperienced decision-makers are taking their evaluation of the existing technology more into account when assessing a cloud-based replacement technology. As a consequence, status quo thinking leads to a more negative assessment of the new technology, which hinders its potentially beneficial introduction to the organizational IT service architecture. Article B investigates decision-making processes related to end-user data protection measures and the impact of psychological ownership on the motivation to protect data. In a questionnaire study and based on the protection motivation theory, the influence of psychological ownership on the decision-making behavior of individuals in both private and work contexts is analyzed. The results demonstrate that psychological ownership exerts a stronger impact on the protection motivation of participants in a private context. The analysis further indicates that employees partly relinquish their responsibility regarding security responses to protect data in their work context. Fostering feelings of psychological ownership could possibly counteract such detrimental effects and improve the adoption of data protection measures in a work context. In Article C, the previously demonstrated cognitive and behavioral aspects of decision-making are contextualized into a holistic conceptual framework. Based on a comprehensive literature analysis and an interview study, this study finds that decisions regarding IT security in companies are influenced by organizational, economic, environmental, cognitive, and behavioral aspects. The literature analysis further demonstrates that existing research still emphasizes economic aspects based on the assumption of purely rational decision-makers. Studies that shed light on IT security decisions from a behavioral, environmental or organizational perspective are significantly less frequent, although the analysis of the expert interviews emphasizes the influence of these aspects. Article D validates that decision-makers in companies are influenced by a variety of aspects when making investment decisions in IT security. The studies of both Article D and Article E aim at decision-makers from small and medium-sized enterprises (SMEs), since an in-depth literature review of existing research in the area of organizational IT security indicates that organizational IT security in SMEs has been largely neglected. The analysis of expert interviews conducted with SME decision-makers, however, indicates that implications of existing research can be transferred only to a limited extent due to unique constraints and their influence on decisions in the SME context. The studies, therefore, investigate and validate the impact of these SME-specific constraints regarding IT security decisions. The findings imply that invest-ment decisions with regard to organizational IT security are strongly influenced by SME-specific characteristics such as insufficient IT budget planning, undocumented processes, or multiple roles due to lack of resources. Consequently, this dissertation provides valuable insights for both practice and research regarding typical and frequent decision-making processes in the context of digital transformation. In particular, this study examines the influence of biases and non-rational aspects in the decision-making process regarding new technologies or measures to ensure their security as well as the effects of SME-specific constraints demonstrate and emphasizes the need for further behavioral research in technology adoption and IT security. |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:dar:wpaper:127806&r= |