nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2023‒05‒08
thirteen papers chosen by

  1. Recursive Preferences, Correlation Aversion, and the Temporal Resolution of Uncertainty By Lorenzo Maria Stanca
  2. Fortune's Formula or the Road to Ruin? The Generalized Kelly Criterion With Multiple Outcomes By Whelan, Karl
  3. Sensitivity Analysis between Lagrange Multipliers and Consumer Budget: Utility Maximization Case By Mohajan, Devajit; Mohajan, Haradhan
  4. The Devil You Know: Rational Inattention to Discrete Choices when Prior Information Matters By Bruno Pellegrino
  5. Mean-field equilibrium price formation with exponential utility By Masaaki Fujii; Masashi Sekine
  6. Testing and Identifying Substitution and Complementarity Patterns By Rui Wang
  7. Optimal self-protection and health risk perception: bridging the gap between risk theory and the Health Belief Model By Emmanuelle Augeraud-Véron; Marc Leandri
  8. Do Consumers Acquire Information Optimally? Experimental Evidence from Energy Efficiency By Andrea La Nauze; Erica Myers
  9. Complexity and Time By Benjamin Enke; Thomas Graeber; Ryan Oprea
  10. Wardrop Equilibrium Can Be Boundedly Rational: A New Behavioral Theory of Route Choice By Jiayang Li; Zhaoran Wang; Yu Marco Nie
  11. Risk Aversion and Favorite-Longshot Bias in a Competitive Fixed-Odds Betting Market By Whelan, Karl
  12. Risk-Taking Behavior during Downturn: Evidence of Loss-Chasing and Realization Effect in the Cryptocurrency Market By Voraprapa Nakavachara; Roongkiat Ratanabanchuen; Kanis Saengchote; Thitiphong Amonthumniyom; Pongsathon Parinyavuttichai; Polpatt Vinaibodee
  13. Identifying Preference for Early Resolution from Asset Prices By Hengjie Ai; Ravi Bansal; Hongye Guo; Amir Yaron

  1. By: Lorenzo Maria Stanca
    Abstract: Models of recursive utility are of central importance in many economic applications. This paper investigates a new behavioral feature exhibited by these models: aversion to risks that exhibit persistence (positive autocorrelation) through time, referred to as correlation aversion. I introduce a formal notion of such a property and provide a characterization based on risk attitudes, and show that correlation averse preferences admit a specific variational representation. I discuss how these findings imply that attitudes toward correlation are a crucial behavioral aspect driving the applications of recursive utility in fields such as asset pricing, climate policy, and optimal fiscal policy.
    Date: 2023–04
  2. By: Whelan, Karl
    Abstract: You can bet on an event where there are multiple possible winners but only one will actually win. At the odds offered, you think there may be multiple bets worth taking. How much do you place on each bet to maximize your expected utility? We describe how this problem can be solved for concave utility functions and illustrate the properties of the solution. The optimal betting strategy is more aggressive than strategies derived from considering each outcome separately such as the Kelly criterion. The strategy also recommends sometimes placing bets with negative expected returns because they act as hedges against losses on other bets. While this strategy maximizes the bettor's subjective expected utility, if betting odds incorporate a profit margin and reflect underlying probabilities correctly, then this more aggressive approach loses more money and results in lower realized utility.
    Keywords: Decision-making under uncertainty; optimal betting; Kelly criterion
    JEL: D81 G11
    Date: 2023–04–05
  3. By: Mohajan, Devajit; Mohajan, Haradhan
    Abstract: In this paper sensitivity analysis between Lagrange multipliers and total budget is discussed. The method of Lagrange multipliers is a very useful and powerful technique in multivariable calculus. In mathematical economics, utility is the vital concept that increases or decreases overall happiness of the consumers. This study tries to discuss utility maximization policy of an organization by considering two constraints: budget constraint and coupon constraint. In this article, an attempt has been taken to achieve the best result through the application of scientific method of optimization.
    Keywords: Budget, Lagrange multipliers, sensitivity analysis, utility maximization
    JEL: C3 C31 C51 C52 C53 C61 C67 C81 I3 O1
    Date: 2023–02–17
  4. By: Bruno Pellegrino
    Abstract: In the seminal rational inattention model of Matĕjka and McKay (2015), logit demand arises from the discrete choice of agents who are uncertain about choice payoffs and have access to a flexible, costly information acquisition technology (RI-logit). A notable limitation of this powerful framework is the lack of known general closed-form solutions that allow the decision maker’s prior information to be asymmetric across choices. In this paper, I solve the RI-logit model analytically for a large family of priors known as multivariate Tempered Stable (TS) distributions. In my analytical formulation, decision makers can be biased, display aversion to prior uncertainty, and thus tend to select choices that are familiar (i.e. for which they hold a less disperse prior). My result extends the applicability of the RI-logit model to a new range of settings where prior information matters. I provide one such application, by showing how it can be used to model the behavior of risk-averse investors who select risky projects in an environment characterized by epistemic uncertainty (risk-adjusted expected returns are unknown, but can be learnt at a cost).
    Keywords: rational inattention, discrete choice, uncertainty
    JEL: D11 D81 D83
    Date: 2023
  5. By: Masaaki Fujii (Quantitative Finance Course, Graduate School of Economics, The University of Tokyo.); Masashi Sekine (Quantitative Finance Course, Graduate School of Economics, The University of Tokyo.)
    Abstract: In this paper, we study a problem of equilibrium price formation among many investors with exponential utility. The investors are heterogeneous in their initial wealth, risk-averseness parameter, as well as stochastic liability at the terminal time. We characterize the equilibrium risk-premium process of the risky stocks in terms of the solution to a novel mean- eld backward stochastic differential equation (BSDE), whose driver has quadratic growth both in the stochastic integrands and in their conditional expectations. We prove the existence of a solution to the mean- eld BSDE under several conditions and show that the resultant risk-premium process actually clears the market in the large population limit.
    Date: 2023–04
  6. By: Rui Wang
    Abstract: This paper studies semiparametric identification of substitution and complementarity patterns between two goods using a panel multinomial choice model with bundles. The model allows the two goods to be either substitutes or complements and admits heterogeneous complementarity through observed characteristics. I first provide testable implications for the complementarity relationship between goods. I then characterize the sharp identified set for the model parameters and provide sufficient conditions for point identification. The identification analysis accommodates endogenous covariates through flexible dependence structures between observed characteristics and fixed effects while placing no distributional assumptions on unobserved preference shocks. My method is shown to perform more robustly than the parametric method through Monte Carlo simulations. As an extension, I allow for unobserved heterogeneity in the complementarity, investigate scenarios involving more than two goods, and study a class of nonseparable utility functions.
    Date: 2023–04
  7. By: Emmanuelle Augeraud-Véron; Marc Leandri
    Abstract: In this contribution to the longstanding risk theory debate on optimal self-protection, we aim to bridge the gap between the microeconomic modeling of self-protection, in the wake of Ehrlich and Becker (1972), and the Health Belief Model, a conceptual framework extremely influential in Public Health studies (Janz and Becker, 1984). In doing so, we highlight the crucial role of risk perception in the individual decision to adopt a preventive behavior towards a generic health risk. We discuss the optimal prevention effort engaged by an agent displaying either imperfect knowledge of the susceptibility (probability of occurrence) or the severity (magnitude of the loss) of a health hazard, or facing uncertainty on these risk components. We assess the impact of risk aversion and prudence on the optimal level of self-protection, an issue at the core of the risk and insurance economic literature. Our results also pave the way for the design of efficient information instruments to improve health prevention when risk perceptions are biased.
    Keywords: Prevention, Self-protection, Health Belief Model, Risk perception, Risk aversion, Prudence
    JEL: D81 I12 D9
    Date: 2023
  8. By: Andrea La Nauze; Erica Myers
    Abstract: We use an experiment to test whether consumers optimally acquire information on energy costs in appliance markets where, like many contexts, consumers are poorly informed and make mistakes despite freely available information. To test for optimal information acquisition we compare the average utility gain from improved decision making due to information with willingness to pay for information. We find that consumers acquire information suboptimally. We then compare two behavioral policies: a conventional subsidy for energy-efficient products and a non-traditional subsidy paying consumers to acquire information on energy costs. The welfare effects of each policy depend on the benefits of improved decisions versus the losses of mental effort (from the information subsidy) or distorted choices (from the product subsidy). In our context, information subsidies dominate product subsidies. In a variety of settings where decisions are made and information is delivered online, paying for attention could more effectively target welfare improvements.
    Keywords: endogenous information acquisition, behavioral bias, information interventions, energy efficiency
    JEL: D91 D12 D83 Q41
    Date: 2023
  9. By: Benjamin Enke; Thomas Graeber; Ryan Oprea
    Abstract: We provide experimental evidence that core intertemporal choice anomalies – including extreme short-run impatience, structural estimates of present bias, hyperbolicity and transitivity violations – are driven by complexity rather than time or risk preferences. First, all anomalies also arise in structurally similar atemporal decision problems involving valuation of iteratively discounted (but immediately paid) rewards. These computational errors are strongly predictive of intertemporal decisions. Second, intertemporal choice anomalies are highly correlated with indices of complexity responses including cognitive uncertainty and choice inconsistency. We show that model misspecification resulting from ignoring behavioral responses to complexity severely inflates structural estimates of present bias.
    Keywords: complexity, hyperbolic discounting, present bias, bounded rationality, noise, cognitive uncertainty
    JEL: C91 D91 G00
    Date: 2023
  10. By: Jiayang Li; Zhaoran Wang; Yu Marco Nie
    Abstract: As one of the most fundamental concepts in transportation science, Wardrop equilibrium (WE) has always had a relatively weak behavioral underpinning. To strengthen this foundation, one must reckon with bounded rationality in human decision-making processes, such as the lack of accurate information, limited computing power, and sub-optimal choices. This retreat from behavioral perfectionism in the literature, however, was typically accompanied by a conceptual modification of WE. Here we show that giving up perfect rationality need not force a departure from WE. On the contrary, WE can be reached with global stability in a routing game played by boundedly rational travelers. We achieve this result by developing a day-to-day (DTD) dynamical model that mimics how travelers gradually adjust their route valuations, hence choice probabilities, based on past experiences. Our model, called cumulative logit (CULO), resembles the classical DTD models but makes a crucial change: whereas the classical models assume routes are valued based on the cost averaged over historical data, ours values the routes based on the cost accumulated. To describe route choice behaviors, the CULO model only uses two parameters, one accounting for the rate at which the future route cost is discounted in the valuation relative to the past ones and the other describing the sensitivity of route choice probabilities to valuation differences. We prove that the CULO model always converges to WE, regardless of the initial point, as long as the behavioral parameters satisfy certain mild conditions. Our theory thus upholds WE's role as a benchmark in transportation systems analysis. It also resolves the theoretical challenge posed by Harsanyi's instability problem by explaining why equally good routes at WE are selected with different probabilities.
    Date: 2023–04
  11. By: Whelan, Karl
    Abstract: Research on sports betting has generally found a favorite-longshot bias: Bets on longshots lose more than bets on favorites. Existing research focuses largely on pari-mutuel betting but favorite-longshot bias is also evident in fixed-odds online betting markets of the type that are growing rapidly around the world. Explanations for this bias in previous work on parimutuel markets cannot explain why it would be a feature of competitive fixed-odds betting markets. We show how disagreement among gamblers and risk-aversion on the part of bookmakers in a competitive market can produce a pattern of favorite-longshot bias resembling the empirical evidence.
    Keywords: Sports Betting, Gambling, Favorite-Longshot Bias, Risk Aversion
    JEL: D81 G14 L83
    Date: 2023–02–09
  12. By: Voraprapa Nakavachara; Roongkiat Ratanabanchuen; Kanis Saengchote; Thitiphong Amonthumniyom; Pongsathon Parinyavuttichai; Polpatt Vinaibodee
    Abstract: Psychologists and economists have both explored how past outcomes influence subsequent risktaking behavior. However, psychologists traditionally focused on gambling, while economists mainly looked at investors’ decisions under uncertainty. As a result, the two fields arrived at different conclusions. Psychology literature identified loss-chasing behavior among casino gamblers and labeled it “compulsive gambling, †a disorder requiring treatment. Economists, on the other hand, introduced a concept of the “realization effect, †suggesting that risk-taking may increase after an unrealized loss but decrease after a realized loss (Imas, 2016). This paper aims to reconcile these two perspectives using empirical evidence from the cryptocurrency market, where gamblers and investors coexist. We find that high-risk individuals increase risk-taking after both unrealized and realized losses. In the most severe case, a one-standard-deviation increase in loss would raise risk-taking, as measured by portfolio volatility, by 58.72%. Thus, high-risk individuals in the cryptocurrency market behave like casino gamblers observed in Psychology literature. On the other hand, low-risk individuals increase risk-taking only after unrealized losses and avoid risks after realized losses. Thus, low-risk individuals in the cryptocurrency market behave like investors facing risky choices, which can be explained by the “realization effect†in Economics literature.
    Keywords: Cryptocurrency; Realization Effect; Loss-Chasing; Behavioral Finance
    JEL: D81 G11 G41
    Date: 2023–04
  13. By: Hengjie Ai; Ravi Bansal; Hongye Guo; Amir Yaron
    Abstract: This paper develops an asset market based test for preference for the timing of resolution of uncertainty. Our main theorem provides a characterization of preference for early resolution of uncertainty in terms of the risk premium of assets realized during the period when the informativeness of macroeconomic announcements is resolved. Empirically, we find support for preference for early resolution of uncertainty based on evidence on the dynamics of the implied volatility of S&P 500 index options before FOMC announcements.
    JEL: D0 D9 D91 G0
    Date: 2023–03

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