nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2023‒07‒10
fifteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Conditions for Extrapolating Differences in Consumption to Differences in Welfare By Wei Zhao; David M. Kaplan
  2. Exponential Utility Maximization in a Discrete Time Gaussian Framework By Yan Dolinsky; Or Zuk
  3. Optimal spending of a wealth fund in the discrete time life cycle model By Aase, Knut K.
  4. Context-Dependent Heterogeneous Preferences: A Comment on Barseghyan and Molinari (2023) By Matias D. Cattaneo; Xinwei Ma; Yusufcan Masatlioglu
  5. Rank-heterogeneous Preference Models for School Choice By Amel Awadelkarim; Arjun Seshadri; Itai Ashlagi; Irene Lo; Johan Ugander
  6. The Emergence of Economic Rationality of GPT By Yiting Chen; Tracy Xiao Liu; You Shan; Songfa Zhong
  7. Financial literacy, experimental preference measures and field behavior – A randomized educational intervention By Matthias Sutter; Michael Weyland; Anna Untertrifaller; Manuel Froitzheim; Sebastian O. Schneider
  8. What Are Reflexive Economic Agents? Position-Adjustment, SLAM, and Self-Organization By Davis, John B.;
  9. At Home versus in a Nursing Home: Long-term Care Settings and Marginal Utility By Bertrand Achou; Philippe De Donder; Franca Glenzer; Minjoon Lee; Marie-Louise Leroux
  10. Reaching an equilibrium of prices and holdings of goods through direct buying and selling By J. Deride; A. Jofr\'e; R. T. Rockafellar
  11. Optimal Market Making in the Chinese Stock Market: A Stochastic Control and Scenario Analysis By Shiqi Gong; Shuaiqiang Liu; Danny D. Sun
  12. Social Preferences: Fundamental Characteristics and Economic Consequences By Ernst Fehr; Gary Charness
  13. A theoretical model-based indirect estimation of the direct and cross price elasticities of demand for tourist goods and services By Asensi Descals-Tormo; Maria J. Murgui-García; Jose Ramon Ruiz-Tamari
  14. Revealed preferences for dynamically inconsistent models By Federico Echenique; Gerelt Tserenjigmid
  15. Uncertainty, risk, and capital growth By Segal, Gill; Shaliastovich, Ivan

  1. By: Wei Zhao (University of Missouri); David M. Kaplan (University of Missouri)
    Abstract: We characterize conditions under which a better consumption distribution implies higher utility. Specifically, when comparing two populations, we consider when one population's first-order stochastic dominance in consumption implies higher expected utility for each subpopulation of individuals who have the same utility function, compared to the corresponding subpopulation of the lower-consumption population. Although this implication seems natural and indeed holds in the familiar case where everyone has the same utility function (risk preferences), we first provide an example in which the opposite occurs: despite worse consumption, expected utility is higher in every subpopulation, essentially by trading consumption risk between subpopulations in ways that are Pareto-improving. We then show that higher expected utility results from higher consumption in different settings. First, we assume a fixed dependence structure (copula) between consumption and preferences, with independence as a special case. Second, viewing the two distributions as treated and untreated potential outcomes, we use the rank invariance assumption from the treatment effects literature, without any explicit restrictions on the consumption--preferences dependence structure. Given that empirical studies only learn about consumption differences, our results help make explicit when such differences can be interpreted as individuals being better off.
    Keywords: copula, first-order stochastic dominance, rank invariance, risk preferences
    JEL: C21 D39 D61
    Date: 2023–06
  2. By: Yan Dolinsky; Or Zuk
    Abstract: The aim of this short note is to present a solution to the discrete time exponential utility maximization problem in a case where the underlying asset has a multivariate normal distribution. In addition to the usual setting considered in Mathematical Finance, we also consider an investor who is informed about the risky asset's price changes with a delay. Our method of solution is based on the theory developed in [4] and guessing the optimal portfolio.
    Date: 2023–05
  3. By: Aase, Knut K. (Dept. of Business and Management Science, Norwegian School of Economics)
    Abstract: The paper analyses optimal spending of an endowment fund. We use the life cycle model for both expected utility and recursive utility in discrete time. First we find the optimal consumption and investment policies for both kinds of utility functions. This we apply to a sovereign wealth fund that invests broadly in the international financial markets. We demonstrate that the optimal spending rate, i.e., the consumption to wealth ratio, is significantly lower than the fund’s expected real rate of return. Using the expected return as the spending rate, implies that the fund’s value converges towards 0 with probability 1 and also in expectation, as time goes. For both kinds of long term convergence we find closed form threshold values. Spending below these values secures that the fund will last ”forever”. For reasonable values of the preference parameters, the optimal spending rate is demonstrated to satisfy these long term requirements.
    Keywords: Life cycle model; optimal spending rate; endowment funds; expected utility; recursive utility; risk aversion; EIS; consumption to wealth ratio; almost sure convergence; 1st mean convergence
    JEL: D51 D53 D90 E21 G10 G12
    Date: 2023–06–09
  4. By: Matias D. Cattaneo; Xinwei Ma; Yusufcan Masatlioglu
    Abstract: Barseghyan and Molinari (2023) give sufficient conditions for semi-nonparametric point identification of parameters of interest in a mixture model of decision-making under risk, allowing for unobserved heterogeneity in utility functions and limited consideration. A key assumption in the model is that the heterogeneity of risk preferences is unobservable but context-independent. In this comment, we build on their insights and present identification results in a setting where the risk preferences are allowed to be context-dependent.
    Date: 2023–05
  5. By: Amel Awadelkarim; Arjun Seshadri; Itai Ashlagi; Irene Lo; Johan Ugander
    Abstract: School choice mechanism designers use discrete choice models to understand and predict families' preferences. The most widely-used choice model, the multinomial logit (MNL), is linear in school and/or household attributes. While the model is simple and interpretable, it assumes the ranked preference lists arise from a choice process that is uniform throughout the ranking, from top to bottom. In this work, we introduce two strategies for rank-heterogeneous choice modeling tailored for school choice. First, we adapt a context-dependent random utility model (CDM), considering down-rank choices as occurring in the context of earlier up-rank choices. Second, we consider stratifying the choice modeling by rank, regularizing rank-adjacent models towards one another when appropriate. Using data on household preferences from the San Francisco Unified School District (SFUSD) across multiple years, we show that the contextual models considerably improve our out-of-sample evaluation metrics across all rank positions over the non-contextual models in the literature. Meanwhile, stratifying the model by rank can yield more accurate first-choice predictions while down-rank predictions are relatively unimproved. These models provide performance upgrades that school choice researchers can adopt to improve predictions and counterfactual analyses.
    Date: 2023–06
  6. By: Yiting Chen; Tracy Xiao Liu; You Shan; Songfa Zhong
    Abstract: As large language models (LLMs) like GPT become increasingly prevalent, it is essential that we assess their capabilities beyond language processing. This paper examines the economic rationality of GPT by instructing it to make budgetary decisions in four domains: risk, time, social, and food preferences. We measure economic rationality by assessing the consistency of GPT decisions with utility maximization in classic revealed preference theory. We find that GPT decisions are largely rational in each domain and demonstrate higher rationality scores than those of humans reported in the literature. We also find that the rationality scores are robust to the degree of randomness and demographic settings such as age and gender, but are sensitive to contexts based on the language frames of the choice situations. These results suggest the potential of LLMs to make good decisions and the need to further understand their capabilities, limitations, and underlying mechanisms.
    Date: 2023–05
  7. By: Matthias Sutter (Max Planck Institute for Research on Collective Goods, Bonn); Michael Weyland (Ludwigsburg University of Education); Anna Untertrifaller (University of Cologne); Manuel Froitzheim (University of Siegen); Sebastian O. Schneider (Max Planck Institute for Research on Collective Goods, Bonn)
    Abstract: We present the results of a randomized intervention to study how teaching financial literacy to 16-year old high-school students affects their behavior in risk and time preference tasks. Compared to two different control treatments, we find that teaching financial literacy makes subjects behave more patiently, more time-consistent, and more risk-averse. These effects persist for up to almost 5 years after our intervention. Behavior in the risk and time preference tasks is related to financial behavior outside the lab, in particular spending patterns. This shows that teaching financial literacy affects economic decision-making which in turn is important for field behavior.
    Keywords: Financial literacy, randomized intervention, risk preferences, time preferences, financial behavior, field experiment
    JEL: C93 D14 I21
    Date: 2023–04
  8. By: Davis, John B. (Department of Economics Marquette University); (Department of Economics Marquette University)
    Abstract: If mainstream economics and its view of economic agents is designed for a world in which reflexivity and feedback processes in the economy are ‘tamed’ and predictable, how are we to understand economic agents in a world in which reflexivity is ‘untamed’ and economies regularly exhibit unexpected fluctuations and significant nonlinearities? In a nonlinear world, economies evolve and undergo critical phase transitions from one form of organization to another. It seems, then, that we should also expect economic agents to evolve and undergo critical phase transitions from being one type of agent to another just as we observe that economies evolve and undergo phase transitions from being one type of economy to another. Minsky’s analysis of how economies evolve in financial crises and how firms as agents evolve as their financial status changes seems a clear example of this. But then we would need a new conception of what economic agents are. This chapter offers such a conception in the idea of reflexive economic agents, both to redevelop an evolutionary, complexity account of what agents must be and also to forestall complexity researchers from falling back upon the standard utility conception of individuals. The chapter builds its reflexive agents conception around Herbert Simon’s complexity thinking about quasi-independence. It describes reflexive economic agents in what it call position-adjustment terms, and focusing on the ‘reflexive moment’ when agents find they need to revise and adjust their positions in regard to what they are doing. To explain how we can understand adjustment, the chapter employs the thinking behind recent ‘simultaneous localization and mapping’ (SLAM) research in robotics engineering to explain how agents understood in position-adjustment terms can be attributed a form of mobility understood as a capacity for self-direction reliant on a kind of locational self-awareness. The chapter then frames the reflexive individual conception that results in terms of Simon’s quasi-independence, evaluates this conception in identity terms, and then returns to the issue of why complex economic systems made up of utility maximizing agents cannot function as evolutionary systems. The chapter closes with a discussion of complex systems seen to evolve through phase transitions.
    Keywords: reflexive agents, complex systems, position-adjustment, SLAM robotics research, phase transitions, Minsky, Simon
    JEL: B41 B52 D91
    Date: 2023–06
  9. By: Bertrand Achou; Philippe De Donder; Franca Glenzer; Minjoon Lee; Marie-Louise Leroux
    Abstract: Marginal utility of financial resources when needing long-term care, and the related incentives for precautionary savings and insurance, may vary significantly by whether one receives care at home or in a nursing home. In this paper, we develop strategic survey questions to estimate those differences. All else equal, we find that the marginal utility is significantly higher when receiving care at home rather than in a nursing home. We then use these estimates within a quantitative life cycle model to evaluate the impact of the expected choice of care setting (home versus nursing home) on precautionary savings and insurance valuation. The estimated marginal utility differences imply a significant increase in the incentives to save when expecting to receive care at home. Larger incentives to self-insure also translate to a higher valuation of additional subsidies for home care than for nursing homes, shedding light on an efficient way to expand public long-term care subsidies. We also examine how the magnitude of our results quantitatively vary with the existing public long-term care subsidies. L’utilité marginale des ressources financières lorsque les personnes nécessitent des soins de longue durée (ainsi que les incitations à épargner et à s’assurer en découlant) peuvent varier substantiellement suivant que les personnes reçoivent ces soins à la maison ou en CHSLD. Dans ce travail, nous développons un sondage en vue d’évaluer ces différences. Toute chose égale par ailleurs, nous montrons que l’utilité marginale des ressources financières est plus élevée pour ceux qui restent chez eux plutôt que d’être en institution. Nos estimés sont ensuite utilisés dans un modèle de cycle de vie de manière à quantifier l’impact d’un choix de résidence spécifique sur l’épargne de précaution et la valorisation de l’assurance. Les différences d’utilité marginale des ressources impliquent que les personnes prévoyant de recevoir des soins à domicile ont des incitatifs plus fortes à épargner. Des incitatifs plus élevés à s’assurer se traduisent par une valorisation plus importante de subventions publiques additionnelles pour les soins à domicile (plutôt qu’en CHSLD), qui devraient donc être privilégiées par les autorités. L’étude examine également comment ces résultats varient en fonction du montant des subventions aux soins de longue durée déjà existantes.
    Keywords: Long-term Care, Marginal Utility, Home Care, Nursing Home, Savings, Soins de longue durée, Utilité marginale, Soins à domicile, Maison de retraite, Ãpargne
    JEL: D14 E21 G51 I10
    Date: 2023–06–09
  10. By: J. Deride; A. Jofr\'e; R. T. Rockafellar
    Abstract: The Walras approach to equilibrium focuses on the existence of market prices at which the total demands for goods are matched by the total supplies. Trading activities that might identify such prices by bringing agents together as potential buyers and sellers of a good are characteristically absent, however. Anyway, there is no money to pass from one to the other as ordinarily envisioned in buying and selling. Here a different approach to equilibrium -- what it should mean and how it may be achieved -- is offered as a constructive alternative. Agents operate in an economic environment where adjustments to holdings have been needed in the past, will be needed again in a changed future, and money is familiar for its role in facilitating that. Marginal utility provides relative values of goods for guidance in making incremental adjustments, and with money incorporated into utility and taken as num\`eraire, those values give money price thresholds at which an agent will be willing to buy or sell. Agents in pairs can then look at such individualized thresholds to see whether a trade of some amount of a good for some amount of money may be mutually advantageous in leading to higher levels of utility. Iterative bilateral trades in this most basic sense, if they keep bringing all goods and agents into play, are guaranteed in the limit to reach an equilibrium state in which the agents all agree on prices and, under those prices, have no interest in further adjusting their holdings. The results of computer simulations are provided to illustrate how this works.
    Date: 2023–05
  11. By: Shiqi Gong; Shuaiqiang Liu; Danny D. Sun
    Abstract: Market making plays a crucial role in providing liquidity and maintaining stability in financial markets, making it an essential component of well-functioning capital markets. Despite its importance, there is limited research on market making in the Chinese stock market, which is one of the largest and most rapidly growing markets globally. To address this gap, we employ an optimal market making framework with an exponential CARA-type (Constant Absolute Risk Aversion) utility function that accounts for various market conditions, such as price drift, volatility, and stamp duty, and is capable of describing 3 major risks (i.e., inventory, execution and adverse selection risks) in market making practice, and provide an in-depth quantitative and scenario analysis of market making in the Chinese stock market. Our numerical experiments explore the impact of volatility on the market maker's inventory. Furthermore, we find that the stamp duty rate is a critical factor in market making, with a negative impact on both the profit of the market maker and the liquidity of the market. Additionally, our analysis emphasizes the significance of accurately estimating stock drift for managing inventory and adverse selection risks effectively and enhancing profit for the market maker. These findings offer valuable insights for both market makers and policymakers in the Chinese stock market and provide directions for further research in designing effective market making strategies and policies.
    Date: 2023–06
  12. By: Ernst Fehr; Gary Charness
    Abstract: We review the vast literature on social preferences by assessing what is known about their fundamental properties, their distribution in the broader population, and their consequences for important economic and political behaviors. We provide, in particular, an overview of the empirically identified characteristics of distributional preferences and how they are affected by merit, luck, and risk considerations as well as by concerns for equality of opportunity. In addition, we identify what is known about belief-dependent social preferences such as reciprocity and guilt aversion. The evidence indicates that the big majority of individuals have some sort of social preference while purely self-interested subjects are a minority. Our review also shows how the findings from laboratory experiments involving social preferences provide a deeper understanding of important field phenomena such as the consequences of wage inequality on work morale, employees’ resistance to wage cuts, individuals’ self-selection into occupations and sectors that are more or less prone to morally problematic behaviors, as well as issues of distributive politics. However, although a lot has been learned in recent decades about social preferences, there are still many important, unresolved, yet exciting, questions waiting to be tackled.
    Date: 2023
  13. By: Asensi Descals-Tormo (Department of Applied Economics, Universitat de València (Spain)); Maria J. Murgui-García (Department of Applied Economics, Universitat de València (Spain)); Jose Ramon Ruiz-Tamari (Department of Applied Economics, Universitat de València (Spain))
    Abstract: Understanding tourist behavior, demand elasticities and the purchasing power of regular tourists visiting a destination is of great interest to the tourism industry for business strategy and to governments for tourism public policy. We propose a new method to empirically estimate own-price and cross-price elasticities of demand for tourist goods and services, as well as an innovative way to measure the average tourist’s marginal utility of income. In the tourism sector we consider that there are two relevant markets, one for tourist goods and services and the other for accommodation. These are separate but interrelated because of the feedback between demands for lodging and tourism products through a vertical relationship of complementarity. The optimal solution to the tourist choice problem consists of a primary demand for tourist services and a derived demand for overnight stays. We focus on obtaining robust estimates of the elasticities corresponding to the former by forecasting the latter. Most of the empirical modeling of tourism demand consists of ad hoc equations that are not directly attached to a specific theoretical framework. Our paper provides a solid characterization of the empirical linkages between the demands for tourist goods and services and accommodation using economic theory. This paper extends existing theory and also makes an important contribution to the empirics of tourism economics, with an application to the tourism database of Australia, Canada, Spain and the United States that quantifies demand elasticities and identities the socioeconomic status of their respective tourists.
    Keywords: Elasticity, Overnight Stay, Preferences, Socioeconomic Status, Tourism Demand, Tourism Destination
    JEL: C51 D12 Z3
    Date: 2023–05–30
  14. By: Federico Echenique; Gerelt Tserenjigmid
    Abstract: We study the testable implications of models of dynamically inconsistent choices when planned choices are unobservable, and thus only "on path" data is available. First, we discuss the approach in Blow, Browning and Crawford (2021), who characterize first-order rationalizability of the model of quasi-hyperbolic discounting. We show that the first-order approach does not guarantee rationalizability by means of the quasi-hyperbolic model. This motivates consideration of an abstract model of intertemporal choice, under which we provide a characterization of different behavioral models -- including the naive and sophisticated paradigms of dynamically inconsistent choice.
    Date: 2023–05
  15. By: Segal, Gill; Shaliastovich, Ivan
    Abstract: We find that high macroeconomic uncertainty is associated with greater accumulation of physical capital, despite a reduction in investment and valuations. To reconcile this puzzling evidence, we show that uncertainty predicts lower depreciation and utilization of existing capital, which dominates the investment slowdown. Motivated by these dynamics, we develop a quantitative production-based model in which firms implement precautionary savings through reducing utilization rather than raising investment. Through this novel intensive-margin mechanism, uncertainty shocks command a quarter of the equity premium in general equilibrium, while flexibility in utilization adjustments helps explain uncertainty risk exposures in the cross-section of industry returns.
    Keywords: Uncertainty, Production, Asset Pricing, Utilization, Depreciation, Equity Premium
    JEL: G12 E32 D81 D50
    Date: 2023

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