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on Utility Models and Prospect Theory |
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Issue of 2022‒02‒21
fifteen papers chosen by |
| By: | Yulei Luo; Jun Nie; Heng-fu Zou |
| Abstract: | Wealth in the utility function (WIU) has been increasingly used in macroeconomic models and this specification can be justified by a few theories such as Max Weber’s (1904-05, German; 1958) theory on “spirit of capitalism.” We incorporate the WIU into a general equilibrium consumption-portfolio choice model to study the implications of the WIU for consumption inequality, equilibrium interest rate, and equity premium—an unexplored area in the literature. Our general equilibrium framework features recursive exponential utility, uninsurable labor risks, and multiple assets and can deliver closed-form solutions to help disentangle the effects of the WIU in driving the key results. We show a stronger preference for wealth lowers the risk-free rate but increases the consumption inequality and equity premium in the equilibrium. We show these properties improve the model’s performance in explaining the data. We also compare the WIU with a closely related hypothesis, habit formation, and find that they have opposite effects on equilibrium asset returns and consumption inequality. |
| Keywords: | Wealth; Spirit of Capitalism; Risk free rates; Risk premia; Savings; Consumption inequality; Wealth inequality |
| JEL: | C61 D81 E21 |
| Date: | 2021–12–22 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedkrw:93600&r= |
| By: | H. Youn Kim (Western Kentucky University); José Alberto Molina (Departamento de Análisis Económico, Universidad de Zaragoza); Ka Kei Gary Wong (University of Macau) |
| Abstract: | This paper jointly analyzes consumer demand and consumption with allowance for durable goods and liquidity constraints. An indirect utility function is specified with the user cost of durable goods, and demand functions for nondurable and durable goods and a consumption growth equation are derived by incorporating liquidity constraints. The model is estimated for Norwegian consumers for 1979-2018, and results reveals that traditional demand analyses ignoring durable goods leads to a significant bias in the elasticities of nondurable goods. Durable goods are found to be necessities and price-inelastic like most nondurable goods. Norwegian consumers are, in general, impatient with low risk aversion. There is weak evidence for liquidity constraints, which have no important influence on consumption. No strong evidence exists for intertemporal substitution in consumption of nondurable and durable goods. However, there is a considerable effect of uncertainty on consumption, especially for durable goods, which can explain consumption/saving behavior during the current Covid pandemic. |
| Keywords: | Indirect utility function, User cost of durable goods, Euler equation, Risk aversion, Intertemporal substitution |
| JEL: | E21 D15 D12 |
| Date: | 2022–01–18 |
| URL: | http://d.repec.org/n?u=RePEc:boc:bocoec:1047&r= |
| By: | Martin M. Andreasen (Aarhus University, CREATES, and the Danish Finance Institute); Giovanni Caggiano (Monash University and University of Padova); Efrem Castelnuovo (University of Padova); Giovanni Pellegrino (Aarhus University) |
| Abstract: | This paper uses a nonlinear vector autoregression and a non-recursive identification strategy to show that an equal-sized uncertainty shock generates a larger contraction in real activity when growth is low (as in recessions) than when growth is high (as in expansions). An estimated New Keynesian model with recursive preferences and approximated to third order around its risky steady state replicates these state-dependent responses. The key mechanism behind this result is that firms display a stronger upward nominal pricing bias in recessions than in expansions, because recessions imply higher inflation volatility and higher marginal utility of consumption than expansions. |
| Keywords: | New Keynesian Model, Nonlinear SVAR, Non-recursive identification, State-dependent uncertainty shock, Risky steady state |
| Date: | 2021–08 |
| URL: | http://d.repec.org/n?u=RePEc:pad:wpaper:0275&r= |
| By: | Ellsaesser, Florian; Fioretti, Guido |
| Abstract: | Sometimes unexpected, novel, unconceivable events enter our lives. The cause-effect mappings that usually guide our behaviour are destroyed. Surprised and shocked by possibilities that we had never imagined, we are unable to make any decision beyond mere routine. Among them there are decisions, such as making investments, that are essential for the long-term survival of businesses as well as the economy at large. We submit that the standard machinery of utility maximization does not apply, but we propose measures inspired by scenario planning and graph analysis, pointing to solutions being explored in machine learning. |
| Keywords: | Uncertainty, Cognitive Maps, Machine Learning, Scenario Planning, Sense-Making, Bounded Rationality |
| JEL: | C8 C81 D8 D81 |
| Date: | 2022–01–10 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:111546&r= |
| By: | Christos Koulovatianos; Carsten Schröder |
| Abstract: | Income-Dependent Equivalence Scales and Choice Theory: Implications for Poverty MeasurementEquivalence Scales are a tool for removing the heterogeneity of household sizes in the measurement of inequality, and affect poverty assessments and poverty lines. We address the disadvantage that poor households may suffer due to their reduced ability to share goods within the household. This disadvantage is important to estimate and embed in standard analysis, as it seems to have a substantial quantitative impact on the measurement of poverty. We also suggest that future research on the role of subsistence incomes of different household types in utility functions may shed light on explanations for poverty and may guide anti-poverty policies. |
| Keywords: | Equivalent incomes, household‐size economies, inequality, demographics and poverty, child costs, Generalized Equivalence Scale Exactness |
| JEL: | I32 D14 D63 D15 |
| Date: | 2022 |
| URL: | http://d.repec.org/n?u=RePEc:diw:diwsop:diw_sp1157&r= |
| By: | Andriy Norets; Kenichi Shimizu |
| Abstract: | We propose a tractable semiparametric estimation method for dynamic discrete choice models. The distribution of additive utility shocks is modeled by location-scale mixtures of extreme value distributions with varying numbers of mixture components. Our approach exploits the analytical tractability of extreme value distributions and the flexibility of the location-scale mixtures. We implement the Bayesian approach to inference using Hamiltonian Monte Carlo and an approximately optimal reversible jump algorithm from Norets (2021). For binary dynamic choice model, our approach delivers estimation results that are consistent with the previous literature. We also apply the proposed method to multinomial choice models, for which previous literature does not provide tractable estimation methods in general settings without distributional assumptions on the utility shocks. We develop theoretical results on approximations by location-scale mixtures in an appropriate distance and posterior concentration of the set identified utility parameters and the distribution of shocks in the model. |
| Keywords: | Dynamic Discrete choice, Bayesian nonparametrics, set identification, location-scale mixtures, MCMC, Hamiltonian Monte Carlo, reversible jump |
| Date: | 2022–02 |
| URL: | http://d.repec.org/n?u=RePEc:gla:glaewp:2022_06&r= |
| By: | S{\o}ren Fiig Jarner |
| Abstract: | In this report we derive the strategic (deterministic) allocation to bonds and stocks resulting in the optimal mean-variance trade-off on a given investment horizon. The underlying capital market features a mean-reverting process for equity returns, and the primary question of interest is how mean-reversion effects the optimal strategy and the resulting portfolio value at the horizon. In particular, we are interested in knowing under which assumptions and on which horizons, the risk-reward trade-off is so favourable that the value of the portfolio is effectively bounded from below on the horizon. In this case, we might think of the portfolio as providing a stochastic excess return on top of a "guarantee" (the lower bound). Deriving optimal strategies is a well-known discipline in mathematical finance. The modern approach is to derive and solve the Hamilton-Jacobi-Bellman (HJB) differential equation characterizing the strategy leading to highest expected utility, for given utility function. However, for two reasons we approach the problem differently in this work. First, we wish to find the optimal strategy depending on time only, i.e., we do not allow for dependencies on capital market state variables, nor the value of the portfolio itself. This constraint characterizes the strategic allocation of long-term investors. Second, to gain insights on the role of mean-reversion, we wish to identify the entire family of extremal strategies, not only the optimal strategies. To derive the strategies we employ methods from calculus of variations, rather than the usual HJB approach. |
| Date: | 2022–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2201.05375&r= |
| By: | Pramanik, Subhajit |
| Abstract: | This article presents a brief analysis of labor supply decision models using the concept of reference-dependent preference. This reference-dependent preference leads the model towards a behavioral aspect where “GainLoss utility” can be derived from standard “consumption utility” and the reference point is determined endogenously by the economic environment. At the first two sections of the article labor supply decision and reference-dependent preference has been discussed in a brief. Then three models has been discussed where the economists used the concept of reference-dependent preference to make labor supply model decisions. |
| Keywords: | Prospect Theory, Behavioral Economics, Labor Supply Decisions, Reference Dependent Preference. |
| JEL: | D01 D03 D7 D78 D81 |
| Date: | 2021–12–02 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:111499&r= |
| By: | Agnes Kovacs (Institute for Fiscal Studies and University of Manchester); Hamish Low (Institute for Fiscal Studies and University of Oxford & Nuffield College); Patrick Moran (Institute for Fiscal Studies and University of Copenhagen) |
| Abstract: | This paper estimates the importance of temptation (Gul and Pesendorfer, 2001) for consumption smoothing and asset accumulation in a structural life-cycle model. We use two complementary estimation strategies: ?rst, we estimate the Euler equation of this model; and second we match liquid and illiquid wealth accumulation using the Method of Simulated Moments. We ?nd that the utility cost of temptation is one-quarter of the utility bene?t of consumption. Further, we show that allowing for temptation is crucial for correctly estimating the elasticity of intertemporal substitution: estimates of the EIS are substantially higher than without temptation. Finally, our Method of Simulated Moments estimation is able to match well the life-cycle accumulation pro?les for both liquid and illiquid wealth only if temptation is part of the preference speci?cation. Our ?ndings on the importance of temptation are robust to the di?erent estimation strategies. |
| Date: | 2020–07–27 |
| URL: | http://d.repec.org/n?u=RePEc:ifs:ifsewp:20/24&r= |
| By: | Caliendo, Marco (University of Potsdam); Cobb-Clark, Deborah A. (University of Sydney); Pfeifer, Harald (BIBB); Uhlendorff, Arne (CREST); Wehner, Caroline (BIBB) |
| Abstract: | We provide the first estimates of the impact of managers' risk preferences on their training allocation decisions. Our conceptual framework links managers' risk preferences to firms' training decisions through the bonuses they expect to receive. Risk-averse managers are expected to select workers with low turnover risk and invest in specific rather than general training. Empirical evidence supporting these predictions is provided using a novel vignette study embedded in a nationally representative survey of firm managers. Risk-tolerant and risk-averse decision makers have significantly different training preferences. Risk aversion results in increased sensitivity to turnover risk. Managers who are risk-averse offer significantly less general training and, in some cases, are more reluctant to train workers with a history of job mobility. All managers, irrespective of their risk preferences, are sensitive to the investment risk associated with training, avoiding training that is more costly or targets those with less occupational expertise or nearing retirement. This suggests the risks of training are primarily due to the risk that trained workers will leave the firm (turnover risk) rather than the risk that the benefits of training do not outweigh the costs (investment risk). |
| Keywords: | manager decisions, employee training, risk attitudes, human capital investments |
| JEL: | J24 D22 D91 |
| Date: | 2022–01 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp15043&r= |
| By: | Matteo M. Marini (Department of Public Economics, Masaryk University, Brno, Czech Republic) |
| Abstract: | This paper is a meta-analysis of experimental studies dealing with the impact of incidental emotions on risky choices, so as to explain traditional heterogeneity of outcomes in the literature. After devising a standard search strategy and filtering out studies that do not comply with a list of eligibility criteria, we include 24 articles from which 109 observations are drawn at the treatment level. At this point, we code a set of moderator variables representing experimental protocols and adopt Hedges’s g as comparable metric of effect size. Subgroup analysis and meta-regressions find causal impact of both sadness and fear on risk aversion, albeit to a small extent, as well as highly contrasting patterns depending on the nature of incentives offered in the experiments. The use of monetary incentives turns out to reduce data variability and affects information processing by making subjects more susceptible to emotions. When studies provide real stakes, our results also show that individualism moderates the relationship between emotions and risk attitude by increasing risk propensity. We discuss possible interpretations of our findings. |
| Keywords: | meta-analysis, experimental design, emotions, risky decision making, monetary incentives, individualism |
| JEL: | C90 C91 D81 D91 |
| Date: | 2022 |
| URL: | http://d.repec.org/n?u=RePEc:jau:wpaper:2022/03&r= |
| By: | Del Campo, Stellio; Anthoff, David; Kornek, Ulrike |
| Abstract: | A sizeable body of literature on climate economics utilizes the notion of inequality aversion. We review and synthesize published estimates of inequality aversion to guide this literature. We review both axiomatic and empirical studies, accordingly our findings draw on different lines of evidence. In the former case, a variety of ethical principles underlie the recommendations for positive inequality aversion. The latter studies use various methods to present estimates based on some form of "revealed ethics," for example by looking at existing progressive income tax-schedules or the level of foreign aid. Here we find strong support for the view that inequality aversion is positive (but potentially small) and very little support for any value larger than three. The vast majority of studies that look at domestic policies support values between one and two, whereas studies that look at foreign aid find lower values ranging from above zero to unity. |
| Keywords: | inequality aversion,marginal valuation of income,Atkinson index,climate change |
| JEL: | D63 I31 Q54 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:esprep:249036&r= |
| By: | Yu-Fu Chen; Hassan Molana |
| Abstract: | We derive a generalised version of the Ramsey-type consumption function when labour income is assumed to follow the standard geometric Brownian motion, and show how the propensity to consume might depend on its drift and diffusion parameters. This enables us to explain the circumstance in which precautionary savings can arise when a risk averse consumer faces income uncertainty, and to resolve the main consumption puzzles: excess smoothness and excess sensitivity of consumption relative to income and its insensitivity to the real interest rate. Our results also show how labour income uncertainty could explain the existence of a subsistence level of consumption and, in that context, shed light on Kuznets’ paradox regarding constancy of the average propensity to consume in the long run. Finally, we find that using the subjective rate of time preference as the sole measure of a consumer’s impatience to consume could be misleading when the path of labour income is volatile. |
| Keywords: | life-cycle model; income volatility; geometric Brownian motion; risk aversion; precautionary savings; excess sensitivity; excess smoothness; Kuznets’ paradox |
| JEL: | C61 D11 E21 D91 D80 |
| Date: | 2022–01 |
| URL: | http://d.repec.org/n?u=RePEc:dun:dpaper:303&r= |
| By: | Holden, Stein T. (Centre for Land Tenure Studies, Norwegian University of Life Sciences); Tilahun, Mesfin (Centre for Land Tenure Studies, Norwegian University of Life Sciences); Sommervoll, Dag Einar (Centre for Land Tenure Studies, Norwegian University of Life Sciences) |
| Abstract: | We use a field experiment and a within-subject design based on multiple Choice Lists (CLs) that integrate time and risk. Diminishing impatience with extended time horizons is studied by varying time horizons from one week to two years. Time-dated risky prospects are constant within CLs and are always compared with time-dated certain amounts to identify time-dated Certainty Equivalents. Non-linear probability weighting is modeled with a 2-parameter Prelec function. First, we identify a strong diminishing impatience associated with longer time delay between prospects. Second, we test whether non-linear probability weighting can explain and reduce the observed diminishing impatience by replacing linear probability weighting with an estimated inverted S-shaped Prelec function. We find that this does not reduce the observed degree of diminishing impatience. We conclude that the observed diminishing impatience is neither explained by the combination of present bias and certainty bias nor by non-linear weighting of risk in future prospects. |
| Keywords: | Time preferences; Diminishing impatience; Risky preferences; Probability weighting; Field experiment; Within-subject design |
| JEL: | C93 D91 |
| Date: | 2022–02–07 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:nlsclt:2022_003&r= |
| By: | Matteo M. Marini (Department of Public Economics, Masaryk University, Brno, Czech Republic) |
| Abstract: | This paper is a follow-up investigation to the aggregate data meta-analysis by Marini (2021), the latter study being designed to detect what experimental protocols moderate the effect of emotions on risk-taking. Our work purports to check the robustness of Marini (2021)’s findings when gender is taken into account as a moderator, as well as to make a contribution to the debate about the role of national culture in risky decision making. The goal is pursued by pooling individual participant data from the subset of studies that make use of multiple price lists as risk elicitation method. We find that gender does not moderate the influence of emotions on risk propensity and we successfully replicate evidence that sadness promotes risk aversion, the use of financial incentives lowers data variability, and subjects take greater risks when studies are conducted in individualist countries. After ruling out the influence of emotions, we still find support for a positive link between individualism and risk-seeking. |
| Keywords: | meta-analysis, gender differences, emotion, risk-taking, individualism |
| JEL: | C91 D81 D91 J16 |
| Date: | 2022 |
| URL: | http://d.repec.org/n?u=RePEc:jau:wpaper:2022/04&r= |