nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2021‒11‒15
thirteen papers chosen by

  1. Accounting for inequality aversion can justify the 2° C goal By Rogna, Marco; Vogt, Carla J.
  2. Expert-based Knowledge: Communicating over Scientific Models By Colo, Philippe
  3. Decrease of capital guarantees in life insurance products: can reinsurance stop it? By Marcos Escobar-Anel; Yevhen Havrylenko; Michel Kschonnek; Rudi Zagst
  4. Reference Points and the Tradeoff between Risk and Incentives By Thomas Dohmen; Arjan Non; Tom Stolp
  5. Consumer Choice under Certainty and Uncertainty in Applied Econometrics By Bernt P. Stigum
  6. Optimal Pairs Trading with Time-Varying Volatility By T. N. Li; A. Tourin
  7. Original divine proportions of general competitive equilibrium By Malakhov, Sergey
  9. A Class of Acceptable and Practical Social Welfare Orderings with Variable Population: Stepwise Social Welfare Orderings and Their Applications By Sakamoto, Norihito; Mori, Yuko
  10. Multidimensional Kyle-Back model with a risk averse informed trader By Shreya Bose; Ibrahim Ekren
  11. Rationality in games and institutions By Van Basshuysen, Philippe
  12. Subjective risk belief function in the field: Evidence from cooking fuel choices and health in India By Yokoo, Hide-Fumi; 横尾, 英史; Arimura, Toshi H.; 有村, 俊秀; Chattopadhyay, Mriduchhanda; Katayama, Hajime; 片山, 東
  13. Reflective Willingness to Pay: Preferences for Sustainable Consumption in a Consumer Welfare Analysis By Inderst, Roman; Thomas, Stefan

  1. By: Rogna, Marco; Vogt, Carla J.
    Abstract: Impact assessment models are a tool largely used to investigate the benefit of reducing polluting emissions and limiting the anthropogenic mean temperature rise. However, they have been often criticised for suggesting low levels of abatement. Countries and regions, that are generally the actors in these models, are usually depicted as having standard concave utility functions in consumption. This, however, disregards a potentially important aspect of environmental negotiations, namely its distributive implications. The present paper tries to fill this gap assuming that countries\regions have Fehr and Schmidt (1999) (F&S) utility functions, specifically tailored for including inequality aversion. Thereby, we propose a new method for the empirical estimation of the inequality aversion parameters by establishing a link between the well known concept of elasticity of marginal utility of consumption and the F&S utility functions, accounting for heterogeneity of countries/regions. By adopting the RICE model, we compare its standard results with the ones obtained introducing F&S utility functions, showing that, under optimal cooperation, the level of temperature rise is significantly lower in the last scenario. In particular, in the last year of the simulation, the optimal temperature rise is 2.1° C. Furthermore, it is shown that stable coalitions are easier to be achieved when F&S preferences are assumed, even if the advantageous inequality aversion parameter (altruism) is assumed to have a very low value. However, self-sustaining coalitions are far from reaching the environmental target of limiting the mean temperature rise below 2° C despite the adoption of F&S utility functions.
    Keywords: Abatement,climate policy,inequality aversion,Paris agreement,RICE model
    JEL: C72 D63 Q54
    Date: 2021
  2. By: Colo, Philippe
    Abstract: Scientific models structure our perception of reality. This paper studies how we choose among them under expert advise. Scientific models are formalised as probability distributions over possible scenarios. An expert is assumed to know the most likely model and seeks to communicate it to a decision maker, but cannot prove it. As a result, communication is a cheap talk game over models. The decision maker is in a situation of model-uncertainty and is ambiguity sensitive. I show that information transmission depends on the strategic misalignment of players and, unlike similar models in the literature, a form of consensus among scientific models. When science is divided, there is an asymmetry in information transmission when the receiver has maxmin expected utility preferences. No information can be conveyed over models above a certain threshold. All equilibria of the game are outcome equivalent to a partitional equilibria and the most informative one is interim Pareto dominant.
    Keywords: Ambiguity, cheap talk
    JEL: C72 D81 D83
    Date: 2021–10–13
  3. By: Marcos Escobar-Anel; Yevhen Havrylenko; Michel Kschonnek; Rudi Zagst
    Abstract: We analyze the potential of reinsurance for reversing the current trend of decreasing capital guarantees in life insurance products. Providing an insurer with an opportunity to shift part of the financial risk to a reinsurer, we solve the insurer's dynamic investment-reinsurance optimization problem under simultaneous Value-at-Risk and no-short-selling constraints. We introduce the concept of guarantee-equivalent utility gain and use it to compare life insurance products with and without reinsurance. Our numerical studies indicate that the optimally managed reinsurance allows the insurer to offer significantly higher capital guarantees to clients without any loss in the insurer's expected utility. The longer the investment horizon and the less risk-averse the insurer, the more prominent the reinsurance benefit.
    Date: 2021–11
  4. By: Thomas Dohmen (IZA (Schaumburg-Lippe-Strasse 5-9, 53113 Bonn, Germany), University of Bonn (Institute for Applied Microeconomics, Adenauerallee 24-42, 53113 Bonn, Germany), Maastricht University (Tongersestraat 53, 6211 LM Maastricht, The Netherlands)); Arjan Non (Erasmus University Rotterdam (E building, Burgemeester Oudlaan 50, 3062 PA Rotterdam, The Netherlands)); Tom Stolp (Maastricht University (Tongersestraat 53, 6211 LM Maastricht, The Netherlands))
    Abstract: We conduct laboratory experiments to investigate basic predictions of principal-agent theory about the choice of piece rate contracts in the presence of output risk, and provide novel insights that reference dependent preferences affect the tradeoff between risk and incentives. Subjects in our experiments choose their compensation for performing a real-effort task from a menu of linear piece rate and fixed payment combinations. As classical principal-agent models predict, more risk averse individuals choose lower piece rates. However, in contrast to those predictions, we find that low-productivity risk averse workers choose higher piece rates when the riskiness of the environment increases. We hypothesize that reference points affect piece rate choice in risky environments, such that individuals whose expected earnings would exceed (fall below) the reference point in a risk-free environment behave risk averse (seeking) in risky environments. In a second experiment, we exogenously manipulate reference points and confirm this hypothesis.
    Keywords: Incentive, piece-rate, risk, reference point, laboratory experiment
    JEL: D81 D91 M52
    Date: 2021–11
  5. By: Bernt P. Stigum
    Abstract: The paper lists salient characteristics of the certainty theory of consumer choice and discusses the import of prominent empirical analyses of the theory. All of them reject the theory’s empirical relevance which suggests that the theory is unfit to analyze consumer choice in an uncertain world. The paper presents an extension of the certainty theory to a theory about consumer choice under uncertainty in which consumer behavior has interesting new properties. I conclude with an empirical test of the empirical relevance of an uncertainty version of Stone’s Linear Expenditure System. In the given empirical context Stone’s System is empirically relevant.
    Keywords: Utility function, linear expenditure system, almost ideal demand system, income and substitution effects, expectations’ effect.
    JEL: A12 B23 B41 C01 C18 C30 C45 C51 C52 D12 D41 D59
    Date: 2021–10–08
  6. By: T. N. Li; A. Tourin
    Abstract: We propose a pairs trading model that incorporates a time-varying volatility of the Constant Elasticity of Variance type. Our approach is based on stochastic control techniques; given a fixed time horizon and a portfolio of two co-integrated assets, we define the trading strategies as the portfolio weights maximizing the expected power utility from terminal wealth. We compute the optimal pairs strategies by using a Finite Difference method. Finally, we illustrate our results by conducting tests on historical market data at daily frequency. The parameters are estimated by the Generalized Method of Moments.
    Date: 2021–11
  7. By: Malakhov, Sergey
    Abstract: The proof of the invisible hand discovers many interesting peculiarities of the general competitive equilibrium at times when Adam Smith was working on the ‘Wealth of Nations’. If his self-interested producer allocates his time between production and delivery to the ‘the door’ of the buyer with zero search costs and unintentionally maximizes customer’s consumption-leisure utility, both the marginal rate of transformation of production into delivery and the marginal rate of substitution of leisure for consumption become equal to the golden ratio conjugate whereas the sales-costs of production ratio becomes equal to the golden ratio itself. While the golden ratio was called by Luca Pacioli, the founder of the modern accounting, as the divine proportion, this paper contributes to the deeper understanding of the Adam Smith’s natural theology approach to the analysis of social processes.
    Keywords: golden ratio, invisible hand, divine proportion, general competitive equilibrium
    JEL: D11 D63 D83
    Date: 2021–10–28
  8. By: Kenneth W. Clements (Economics Department, Business School, The University of Western Australia); Long Hai Vo (Economics Department, Business School, The University of Western Australia)
    Abstract: There are significant disparities in the wealth of nations and how incomes are spent. For example, consumers in the poorest countries spend more than half of income on food, while in the richest countries, this is one-tenth or less. We use the recently published data from the International Comparison Program for 176 countries to estimate cross-country demands. Considerable progress can be made in accounting for much of the disparities in consumption patterns with this simple utility-maximisation model in which variations in incomes and prices are the key drivers. This leads to measures of the “quality” of consumption and its price based on a luxury-necessity-revealed-preference approach, as well as projections of future world food demand.
    Keywords: Global consumption; Quality indexes; Engel’s law; Food demand projections
    JEL: D12 F61 Q11
    Date: 2021
  9. By: Sakamoto, Norihito; Mori, Yuko
    Abstract: This study proposes a new class of social welfare orderings, a stepwise rank-dependent social welfare ordering, which naturally generalizes a rank-dependent utilitarianism in the setting of social choice with variable population size. In fact, a stepwise social welfare ordering is simply designed to have the same value for each proportion of the population, with the obvious advantage that allows functional form to be freely chosen for assessing well-being inequality. We show that a stepwise rank-dependent social welfare ordering is easily characterized by standard axioms: strong Pareto, anonymity, Pigou-Dalton transfer equity, continuity, rank-separability, and consistency for population replication. If additional requirements on standard invariance are imposed on it, its functional form is specified as a well-known rank-weighted social welfare ordering. As some practical applications to measure social welfare, we propose three simple methods such as a quantile mean comparison method, which evaluates social welfare by comparing each quantile’s average income in an approximate lexicographic ordering or quantile-dependent weighted summation. These applications have obvious advantages in that they can see the whole picture of income distributions compared with standard tools such as the traditional GDP per capita, median, range, and top/bottom ratios. Furthermore, we show a representation theorem that generalizes stepwise social welfare orderings for the problem of optimal population size.
    Keywords: Stepwise Social Welfare Orderings, Quantile Mean Comparison, Interval Population-Ratio Comparison, Interval Weighted Mean Comparison
    JEL: D63 D71 H43 I31 I32 J18 Q56
    Date: 2021–10
  10. By: Shreya Bose; Ibrahim Ekren
    Abstract: We study the continuous time Kyle-Back model with a risk averse informed trader.We show that in a market with multiple assets and non-Gaussian prices an equilibrium exists. The equilibrium is constructed by considering a Fokker-Planck equation and a system of partial differential equations that are coupled with an optimal transport type constraint at maturity.
    Date: 2021–11
  11. By: Van Basshuysen, Philippe
    Abstract: Against the orthodox view of the Nash equilibrium as “the embodiment of the idea that economic agents are rational” (Aumann, 1985, p 43), some theorists have proposed ‘non-classical’ concepts of rationality in games, arguing that rational agents should be capable of improving upon inefficient equilibrium outcomes. This paper considers some implications of these proposals for economic theory, by focusing on institutional design. I argue that revisionist concepts of rationality conflict with the constraint that institutions should be designed to be incentive-compatible, that is, that they should implement social goals in equilibrium. To resolve this conflict, proponents of revisionist concepts face a choice between three options: (1) reject incentive compatibility as a general constraint, (2) deny that individuals interacting through the designed institutions are rational, or (3) accept that their concepts do not cover institutional design. I critically discuss these options and I argue that a more inclusive concept of rationality, e.g. the one provided by Robert Sugden’s version of team reasoning, holds the most promise for the non-classical project, yielding a novel argument for incentive compatibility as a general constraint.
    Keywords: concept formation; game theory; institutional design; rationality; Robert Sugden; team reasoning
    JEL: J1
    Date: 2021
  12. By: Yokoo, Hide-Fumi; 横尾, 英史; Arimura, Toshi H.; 有村, 俊秀; Chattopadhyay, Mriduchhanda; Katayama, Hajime; 片山, 東
    Abstract: We investigate the accuracy of the perceptions of health risks in India. The context of our study is the risk of developing physical symptoms related to household air pollution caused by cooking. Using field data collected from 588 respondents in 17 villages in West Bengal, we regress the probability of symptoms on fuel choices to predict respondent-specific health risk changes. The estimated risks, which we treat as objective risks, are then compared with the corresponding subjective probabilistic beliefs, which are elicited by an interactive method with visual aids. Our results show that, on average, the respondents slightly underestimate the change in risk when switching from cooking with firewood to cooking with liquefied petroleum gas, even though their beliefs are qualitatively correct. The results further show that risk misperception is associated only with religion among individuals’ observed characteristics, suggesting that their unobserved characteristics play a substantial role in risk misperception.
    Keywords: Belief, Cooking fuel choice, Health risk, India, Risk misperception, Subjective probabilistic expectation
    JEL: D83 D84 I12 O13 Q53
    Date: 2021–11
  13. By: Inderst, Roman; Thomas, Stefan
    Abstract: Our starting point is the following simple but potentially underappreciated observation: When assessing willingness to pay (WTP) for hedonic features of a product, the results of such measurement are influenced by the context in which the consumer makes her real or hypothetical choice or in which the questions to which she replies are set (such as in a contingent valuation analysis). This observation is of particular relevance when WTP regards sustainability, the "non-use value" of which does not derive from a direct (physical) sensation and where perceived benefits depend heavily on available information and deliberations. The recognition of such context sensitivity paves the way for a broader conception of consumer welfare (CW), and our proposed standard of "reflective WTP" may materially change the scope for private market initiatives with regards to sustainability, while keeping the analytical framework within the realm of the CW paradigm. In terms of practical implications, we argue, for instance, that actual purchasing decisions may prove insufficient to measure consumer appreciation of sustainability, as they may rather echo learnt but unreflected heuristics and may be subject to the specific shopping context, such as heavy price promotions. Also, while it may reflect current social norm, the latter may change considerably over time as more consumers adopt their behavior.
    Keywords: Antitrust,Consumer Welfare,Sustainability
    JEL: A13 K21 K32
    Date: 2021

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