nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2022‒02‒28
eighteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. The Atlas of Inequality Aversion: Theory and Empirical Evidence from the Luxembourg Income Study Database By Stanislaw Maciej Kot; Piotr Paradowski
  2. The Benefits of Coarse Preferences By Halpern, Joe; Heller, Yuval; Winter, Eyal
  3. Pricing principle via Tsallis relative entropy in incomplete market By Dejian Tian
  4. Altruism Networks, Income Inequality, and Economic Relations By Yann Bramoullé; Rachel Kranton
  5. Asset Prices Under Knightian Uncertainty By Roman Frydman; Soren Johansen; Anders Rahbek; Morten Nyboe Tabor
  6. Extreme inflation and time-varying expected consumption growth By Dergunov, Ilya; Meinerding, Christoph; Schlag, Christian
  7. What's the Risk from Competing? Competition Aversion and the Gender Wage Gap By Choe, Chung; Jungy, SeEun; Oaxaca, Ronald L.
  8. Keynes's Treatise on Probability 100 Years Later: Small vs. large worlds and closed vs. open systems By Davis, John B.
  9. Complete Markets with Bankruptcy Risk and Pecuniary Default Penalties By Victor Filipe Martins da Rocha; Rafael Mouallem Rosa
  10. Maximizing the Out-of-Sample Sharpe Ratio By Lassance, Nathan
  11. Building a Bayesian decision support system for evaluating COVID-19 countermeasure strategies By Strong, Peter; Shenvi, Aditi; Yu, Xuewen; Papamichail, K. Nadia; Wynn, Henry P.; Smith, Jim Q.
  12. Optimal Labor Income Taxation - The Role of the Skill Distribution By Dingquan Miao
  13. The Marginal Propensity to Consume During the COVID-19 Pandemic: Evidence from Thailand and Vietnam By Bui, Dzung; Dräger, Lena; Hayo, Bernd; Nghiem, Giang
  14. Intertemporal Consumption and Debt Aversion: A Replication and Extension By Steffen Ahrens; Ciril Bosch-Rosa; Thomas Meissner
  15. Agency, Benevolence and Justice By Prithvijit Mukherjee; J. Dustin Tracy
  16. A convenient truth : between-subject random incentives and preferences towards risk and time By Noémi Berlin; Emmanuel Kemel; Vincent Lenglin; Antoine Nebout-Javal
  17. How Various “Irrationalities” Proven to be Rational By Li, Bin
  18. Child Labour Ethics through the Prism of Utilitarianism and Deontology By Krummel, Daniel; Siegfried, Patrick

  1. By: Stanislaw Maciej Kot; Piotr Paradowski
    Abstract: In the distributive analysis, the constant relative inequality aversion utility function is a standard tool for ethical judgements of income distributions. The sole parameter ? of this function expresses a society’s aversion to inequality. However, the profession has not committed to the range of ?. This paper aims to estimate the parameter ? of the constant relative inequality aversion utility function using datasets available from the Luxembourg Income Study Database. We utilise the method of estimating ? assuming incomes obey the generalised beta distribution of the second kind. The estimator of ? is derived from the mathematical condition of the existence of the social welfare function. We elaborate an ‘atlas’ of 388 estimates of ? for 55 countries across time. We also verify two hypotheses: 1) The richer the country, the greater the societal inequality aversion; 2) The greater (lower) the inequality aversion, the lower (greater) income inequality. Our data do not confirm the 1st hypothesis. For verifying the 2nd hypothesis, we use the inequality-development relationship augmented by inequality aversion. The 2nd hypothesis is unfalsified in about 90% of country-year cases.
    JEL: C10 D30 D60 I30 O15
    Date: 2022–01
  2. By: Halpern, Joe; Heller, Yuval; Winter, Eyal
    Abstract: We study the strategic advantages of coarsening one’s utility by clustering nearby payoffs together (i.e., classifying them the same way). Our solution concept, coarse-utility equilibrium (CUE) requires that (1) each player maximizes her coarse utility, given the opponent’s strategy, and (2) the classifications form best replies to one another. We characterize CUEs in various games. In particular, we show that there is a qualitative difference between CUEs in which only one of the players clusters payoffs, and those in which all players cluster their payoffs, and that the latter type induce players to treat co-players better than in Nash equilibria in the large class of games with monotone externalities.
    Keywords: Categorization, language, indirect evolutionary approach, monotone externalities, strategic complements, strategic substitutes.
    JEL: C73 D83
    Date: 2022–01–25
  3. By: Dejian Tian
    Abstract: A pricing principle is proposed for non-attainable $q$-exponential bounded contingent claims in an incomplete Brownian motion market setting. This pricing functional is compatible with prices for attainable claims, and it is defined by the solution of a specific quadratic backward stochastic differential equation (BSDE). Except translation invariance, the pricing principle processes lots of elegant properties, such as monotonicity, time consistency, concavity etc. Tsallis relative entropy theory is found to be closely related to this pricing criterion. The buyer evaluates the contingent claim under the ``distorted Radon-Nikodym derivative'' and adjustment by Tsallis relative entropy over a family of equivalent martingale measures. The asymptotic behavior of the pricing principle for risk aversion coefficient is also investigated. The pricing functional is proved between minimal martingale measure pricing and conditional certainty equivalence of $q$-exponential utility.
    Date: 2022–01
  4. By: Yann Bramoullé (AMSE - Aix-Marseille Sciences Economiques - EHESS - École des hautes études en sciences sociales - AMU - Aix Marseille Université - ECM - École Centrale de Marseille - CNRS - Centre National de la Recherche Scientifique); Rachel Kranton (Duke University [Durham])
    Abstract: What patterns of economic relations arise when people are altruistic rather than strategically self-interested? This paper introduces an altruism network into a simple model of choice among partners for economic activity. With concave utility, agents effectively become inequality averse towards friends and family. Rich agents preferentially choose to work with poor friends despite productivity losses. Hence, network inequality-the divergence in incomes within sets of friends and family-is key to how altruism shapes economic relations and output. Skill homophily also plays a role; preferential contracts and productivity losses decline when rich agents have poor friends with requisite skills.
    Date: 2022–02–09
  5. By: Roman Frydman (Department of Economics, New York University); Soren Johansen (Department of Economics, University of Copenhagen); Anders Rahbek (Department of Economics, University of Copenhagen); Morten Nyboe Tabor (Institute for New Economic Thinking)
    Abstract: We extend Lucas's classic asset-price model by opening the stochastic process driving dividends to Knightian uncertainty arising from unforeseeable change. Implementing Muth's hypothesis, we represent participants' expectations as being consistent with our model's predictions and formalize their ambiguity-averse decisions with maximization of intertemporal multiple-priors utility. We characterize the asset-price function with a stochastic Euler equation and derive a novel prediction that the relationship between prices and dividends undergoes unforeseeable change. Our approach accords participants' expectations, driven by both fundamental and psychological factors, an autonomous role in driving the asset price over time, without presuming that participants are irrational.
    Keywords: Asset Prices; Unforeseeable Change; Knightian Uncertainty; Muth's Hypothesis; Model Ambiguity; Rational Expectations (REH); Behavioral Finance.
    JEL: D84 E00 G12 G41
    Date: 2021–12–07
  6. By: Dergunov, Ilya; Meinerding, Christoph; Schlag, Christian
    Abstract: In a parsimonious regime switching model, we find strong evidence that expected consumption growth varies over time. Adding inflation as a second variable, we uncover two states in which expected consumption growth is low, one with high and one with negative expected inflation. Embedded in a general equilibrium asset pricing model with learning, these dynamics replicate the observed time variation in stock return volatilities and stockbond return correlations. They also provide an alternative derivation for a measure of time-varying disaster risk suggested by Wachter (2013), implying that both the disaster and the long-run risk paradigm can be extended towards explaining movements in the stock-bond correlation.
    Keywords: Long-run risk,inflation,recursive utility,filtering,disaster risk
    JEL: E31 E44 G12
    Date: 2022
  7. By: Choe, Chung (Konkuk University); Jungy, SeEun (Inha University); Oaxaca, Ronald L. (University of Arizona)
    Abstract: Laboratory experiments involving a real effort task are conducted to examine the importance of gender differences in competition aversion for generating gender wage gaps. Cross-subject design treatment and control experiments suggest that gender differences in risk aversion play no significant role in competitive (tournament) vs. piece-rate job choices and consequent gender wage gaps. Subjects in the treatment experiments are sorted into relatively more and relatively less risk averse groupings. Relatively less risk averse subjects are assigned to a risky job track involving a known constant probability of unemployment in each period. The gender wage gap contribution of gender differences in competition aversion compared with the contribution of gender differences in performance is especially large for relatively less risk averse subjects.
    Keywords: gender wage gaps, wage decompositions, competition preferences, risk aversion, lab experiments
    JEL: J16 J31 C91 D91
    Date: 2022–01
  8. By: Davis, John B. (Department of Economics Marquette University)
    Abstract: The meaning and significance of Keynes’s Treatise on Probability has changed over the 100 years since its publication. Initially it stood on its own as an original contribution to probability theory. After The General Theory some saw the Treatise strengthening Keynes’s later arguments. Yet by the time New Classical Economics became dominant it became largely ignored. This paper attributes that later rejection to the mainstream economics’ reliance on Savage’s subjective expected utility restriction of probability thinking to what he called small worlds. It argues that his small worldslarge worlds distinction produces a small worlds-closed worlds conception of economics the mainstream employs, and that Keynesian economic thinking and the Treatise employ a large worlds-open worlds conception of economics. It frames this open-closed opposition in terms of two contrasting conceptions of science from 1930s system theory, and argues that in economics it is the basis for two conceptions of time: a static, before-after view of temporal sequences and a dynamic, past-present-future view of temporal sequences. The paper then shifts to how Sraffa explained the relationship between production and distribution as an interaction between a relatively closed production system open to distributional forces, shows an analogous view exists in the later thinking of Wittgenstein with whom Sraffa interacted, and then argues Keynes’s thinking in the Treatise employs a similar Cambridge understanding whereby our probability judgments are relatively closed but also open to fundamental uncertainty.
    Keywords: Keynes, Treatise on Probability, Savage, small worlds, closed worlds, open systems, closed systems, Sraffa, Wittgenstein
    JEL: B29 B30 C10 C11
    Date: 2022–01
  9. By: Victor Filipe Martins da Rocha (LEDa - Laboratoire d'Economie de Dauphine - IRD - Institut de Recherche pour le Développement - Université Paris Dauphine-PSL - PSL - Université Paris sciences et lettres - CNRS - Centre National de la Recherche Scientifique, EESP - Sao Paulo School of Economics - FGV - Fundacao Getulio Vargas [Rio de Janeiro]); Rafael Mouallem Rosa (EESP - Sao Paulo School of Economics - FGV - Fundacao Getulio Vargas [Rio de Janeiro])
    Abstract: For an infinite horizon economy with complete contingent markets, bankruptcy risk, and linear utility penalties for default, Araujo and Sandroni (1999) and Araujo, Da Silva, and Faro (2016) show that if agents have heterogeneous beliefs, then a competitive equilibrium without bankruptcy does not exist. The first contribution of this paper is to show that even if all agents have homogenous beliefs, the existence of an equilibrium is guaranteed only under stringent conditions on default penalty rates. In order to discourage agents from making promises that they know in advance they will not be able to honor, default penalty rates must be large enough. Are the "real-life" default penalties sufficiently harsh? Since utility penalties are difficult to measure in practice, we propose to address this question by replacing the "reduced-form" linear default penalties with pecuniary punishments in the line of Kehoe and Levine (1993). We show that, independently of the severity of the pecuniary punishment, an equilibrium without bankruptcy never exists.
    Date: 2022
  10. By: Lassance, Nathan (Université catholique de Louvain, LIDAM/LFIN, Belgium)
    Abstract: Maximizing the out-of-sample Sharpe ratio is an important objective for investors. To achieve this, we characterize optimal portfolio combinations maximizing expected out-of-sample Sharpe ratio. When investing in the risk-free asset is allowed and combination coefficients are unconstrained, as in Kan and Zhou (2007), we uncover that combining portfolios to maximize expected out-of-sample utility optimizes expected outof-sample Sharpe ratio as well. However, the two criteria are not equivalent for portfolios fully invested in risky assets, and in this case we show how to adapt the optimal portfolio combination of Kan, Wang, and Zhou (2021) to maximize expected out-of-sample Sharpe ratio. We find that the proposed mean-variance portfolio combinations calibrated to maximize expected out-of-sample Sharpe ratio generally outperform the considered benchmarks. Relative to the minimum-variance portfolio estimated with a nonlinearly shrunk covariance matrix, the annualized out-of-sample Sharpe ratio increases from 0.988 to 1.110 before transaction costs, and from 0.914 to 1.007 net of transaction costs, on average across four typical datasets.
    Keywords: Mean-variance portfolio ; parameter uncertainty ; estimation risk ; out-of-sample performance
    Date: 2021–12–23
  11. By: Strong, Peter; Shenvi, Aditi; Yu, Xuewen; Papamichail, K. Nadia; Wynn, Henry P.; Smith, Jim Q.
    Abstract: Decision making in the face of a disaster requires the consideration of several complex factors. In such cases, Bayesian multi-criteria decision analysis provides a framework for decision making. In this paper, we present how to construct a multi-attribute decision support system for choosing between countermeasure strategies, such as lockdowns, designed to mitigate the effects of COVID-19. Such an analysis can evaluate both the short term and long term efficacy of various candidate countermeasures. The expected utility scores of a countermeasure strategy capture the expected impact of the policies on health outcomes and other measures of population well-being. The broad methodologies we use here have been established for some time. However, this application has many novel elements to it: the pervasive uncertainty of the science; the necessary dynamic shifts between regimes within each candidate suite of countermeasures; and the fast moving stochastic development of the underlying threat all present new challenges to this domain. Our methodology is illustrated by demonstrating in a simplified example how the efficacy of various strategies can be formally compared through balancing impacts of countermeasures, not only on the short term (e.g. COVID-19 deaths) but the medium to long term effects on the population (e.g. increased poverty).
    Keywords: Covid-19; decision support system; expected utility; emergency management; multi-criteria; evaluation methodology; coronavirus
    JEL: C1
    Date: 2022–01–18
  12. By: Dingquan Miao
    Abstract: I analyze the role of the distribution of skills in shaping optimal nonlin-ear income tax schedules. I use theoretical skill distributions as well as empirical skill distributions for 14 OECD countries. I find that a more dispersed log-normal skill distribution implies a more progres-sive optimal tax schedule. Optimal tax rates should be lower through-out if a greater number of unskilled agents cluster at the bottom, and the scheme is more progressive if a greater number of agents locate at the top. I also highlight how the impact of the skill distribution is affected by the form of the social welfare function and the utility function. The findings using empirical skill distributions suggest that the results are sensitive to the type of statistical estimator used to estimate the skill distribution.
    JEL: H21 J24
    Date: 2022–01
  13. By: Bui, Dzung; Dräger, Lena; Hayo, Bernd; Nghiem, Giang
    Abstract: In evaluating surveys conducted in Thailand and Vietnam during the COVID-19 pandemic, we find that the marginal propensity to consume is significantly larger for positive than for negative income shocks. This result contradicts a prediction from the lifecycle permanent income model with borrowing constraints as well as empirical evidence from industrialized countries. However, our finding is consistent with Kahneman and Tversky’s prospect theory, according to which the combination of income uncertainty and loss aversion can induce households to react more strongly to positive than to negative shocks.
    Keywords: Marginal propensity to consume (MPC); Unanticipated income shocks; COVID-19; Thailand; Vietnam
    JEL: E21 H31 D84
    Date: 2022–02
  14. By: Steffen Ahrens; Ciril Bosch-Rosa; Thomas Meissner
    Abstract: We replicate Meissne (2016) where debt aversion was reported for the first time in an intertemporal consumption and saving problem. While Meissner (2016) uses a German sample, our subjects are US undergraduate students. All of the main findings from the original study replicate, with similar effect sizes. Additionally, we extend the original analysis by correlating a new individual index of debt aversion on individual characteristics such as gender, cognitive ability, and risk aversion. The findings suggest that gender and risk aversion are not correlated with debt aversion. However, cognitive ability is positively correlated with debt aversion. Overall, this paper confirms the importance of debt aversion in intertemporal consumption problems and validates the approach of Meissner (2016).
    Date: 2022–01
  15. By: Prithvijit Mukherjee (Mount Holyoke College); J. Dustin Tracy (Economic Science Institute, Chapman University)
    Abstract: We test for social norms regarding how agents should select between risky prospects for principals, including norms consistent with beneficence and justice propositions from Adam Smith. We elicit norms from subjects serving as “impartial spectator[s]†about choice of risky prospect selected by the agents. We find strong evidence for the existence of norms, consistent with the Smith propositions. Furthermore we find that agents are more likely to select more normative options. In contrast, we find that principals’ allocation for bonuses depends on the realization of the risky prospect rather than whether the agents choice was consistent with the norm.
    Keywords: Social norms, Decisions-making for others, Laboratory experiments, Principal-Agent, Decisionmaking under risk
    JEL: C9 D63 D81 D90 G41
    Date: 2022
  16. By: Noémi Berlin (EconomiX - UPN - Université Paris Nanterre - CNRS - Centre National de la Recherche Scientifique, CNRS - Centre National de la Recherche Scientifique); Emmanuel Kemel; Vincent Lenglin; Antoine Nebout-Javal
    Date: 2022–01–18
  17. By: Li, Bin
    Abstract: Various“irrationalities” have always been deemed distinct from human reason or “rational thinking”. However, another long-standing view is that“irrationalities” are really some kinds of rationality that just need to be somehow proven. It would be most satisfactory if the proof could be done because a successful proof can re-justify the mainstream rational principle, then minimizing the price of reform of economics. This paper briefly introduces a ready-made solution.
    Keywords: irrationality; rationality; behavioral economics; psychology; animal spirits; bounded rationality
    JEL: A10 B00 C60
    Date: 2022–01–06
  18. By: Krummel, Daniel; Siegfried, Patrick
    Abstract: Purpose: Grounded in the theoretical concepts of utilitarianism and deontology, this paper aims to evaluate the issue of child labour from an ethics perspective. By linking utilitarianism with normative stakeholder theory, relevant stakeholder groups are being identified in order to examine their influence on and role in the occurrence of child labour allowing for a practical reference. The findings may serve companies in particular as a basis for decision-making in the development of their value chains. Design/Methodology/Approach: The author uses a literature review in order to analyze the findings of existing literature on the topic of child labour in an ethics context, thereby drawing on literature, indexed in Web of Science and Google Scholar by employing forward and backward citation analysis. Findings: The investigation of child labour in terms of ethics yields conflicting results. From a deontological perspective, child labour can never be ethical and should always be rejected as it is not wanted to become a general law. In contrast, according to a utilitarian sentiment, child labour is ethically justifiable as long as the beneficiaries of the labour are greater in number than the children working or suffering. Originality/Value: The examination of child labour from the perspective of deontology and utilitarianism in conjunction with normative stakeholder theory constitutes a novelty in the ethics literature. The integration of theoretical findings into a practical business context provides additional value for managers and global supply chain managers.
    Keywords: Business Ethics and Corporate Social Responsibility
    JEL: J1 M1 M14
    Date: 2021–02–09

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