nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2023‒07‒31
fourteen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Recursive Preferences and Ambiguity Attitudes By Massimo Marinacci; Giulio Principi; Lorenzo Stanca
  2. Recursive Preferences, Correlation Aversion, and the Temporal Resolution of Uncertainty By Lorenzo Stanca
  3. Prospect theory’s loss aversion is robust to stake size By Han Bleichrodt; Olivier L’haridon
  4. Heterogeneity in health insurance choice: An experimental investigation of consumer choice and feature preferences By Hermanns, Benedicta; Kairies-Schwarz, Nadja; Kokot, Johanna; Vomhof, Markus
  5. The Anomalies Of The Wold-Juréen (1953) Functional Form In Overview By Sproule, Robert
  6. The Classical Theory of Supply and Demand By Sabiou Inoua; Vernon Smith
  7. Are Shortfall Systemic Risk Measures One Dimensional? By Alessandro Doldi; Marco Frittelli; Emanuela Rosazza Gianin
  8. Time-Varying Risk Aversion and International Stock Returns By Massimo Guidolin; Erwin Hansen; Gabriel Cabrera
  9. Mind the Cap! -- Constrained Portfolio Optimisation in Heston's Stochastic Volatility Model By Marcos Escobar-Anel; Michel Kschonnek; Rudi Zagst
  10. A Classical Model of Speculative Asset Price Dynamics By Sabiou Inoua; Vernon Smith
  11. The Power of Menus in Contract Design By Guru Guruganesh; Jon Schneider; Joshua Wang; Junyao Zhao
  12. How Good Are Privacy Guarantees? Platform Architecture and Violation of User Privacy By Daron Acemoglu; Alireza Fallah; Ali Makhdoumi; Azarakhsh Malekian; Asuman Ozdaglar
  13. The Welfare Economics of Reference Dependence By Daniel Reck; Arthur Seibold
  14. Is Having an Expert “Friend†Enough? An Analysis of Consumer Switching Behavior in Mobile Telephony By Genakos, C.; Roumanias, C.; Valletti, T.

  1. By: Massimo Marinacci; Giulio Principi; Lorenzo Stanca
    Abstract: We illustrate the strong implications of recursivity, a standard assumption in dynamic environments, on attitudes toward uncertainty. In intertemporal consumption choice problems, recursivity always implies constant absolute ambiguity aversion (CAAA) when applying the standard dynamic extension of monotonicity. Our analysis also yields a functional equation called “generalized rectangularity†, as it generalizes the standard notion of rectangularity for recursive maxmin preferences to general certainty equivalents. Our results highlight that if uncertainty aversion is modeled as a form of convexity of preferences, recursivity limits us to only recursive variational preferences.
    Keywords: Dynamic choice, recursive utility, uncertainty aversion, absolute attitudes, generalized rectangularity.
    Date: 2023
  2. By: Lorenzo 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.
    Keywords: Intertemporal substitution, risk aversion, correlation aversion, recursive utility, preference for early resolution of uncertainty, information.
    Date: 2023
  3. By: Han Bleichrodt (UA - Université d'Alicante, Espagne); Olivier L’haridon (CREM - Centre de recherche en économie et management - UNICAEN - Université de Caen Normandie - NU - Normandie Université - UR - Université de Rennes - CNRS - Centre National de la Recherche Scientifique)
    Abstract: Several papers have challenged the robustness of loss aversion, claiming that it is context-dependent and disappears for small stakes. These papers use a behavioral definition of loss aversion that may be confounded by diminishing sensitivity and probability/event weighting under the new version of prospect theory (PT). We perform a new theory-based test of loss aversion that controls for these confounds. We found significant loss aversion for both small stakes and high stakes. The overall loss aversion coefficient varied between 1.25 and 1.45, less than commonly observed. Loss aversion decreased slightly for small stakes, but the effect was small and usually insignificant. Overall, our results indicate that, under PT, loss aversion is robust to stake size. © 2023, Society for Judgment and Decision making. All rights reserved.
    Keywords: context dependence, loss aversion, measurement
    Date: 2023
  4. By: Hermanns, Benedicta; Kairies-Schwarz, Nadja; Kokot, Johanna; Vomhof, Markus
    Abstract: We investigate heterogeneity in patterns of preferences for health insurance features using health insurance choice data from a controlled laboratory experiment. Within the experiment, participants make consecutive insurance choices based on choice sets that vary in composition and size. We keep the health risk constant and equal for everyone. In addition, we implement a treatment that entails a feature-based insurance filter, allowing us to validate feature preferences. We also account for individually elicited risk preferences. On aggregate, we find that there is considerable heterogeneity in consumer choice. Participants differ particularly (a) in their willingness to pay to insure themselves against illnesses that differ in terms of their probability of occurrence and the size of the losses to be covered and (b) in their preference to forgo deductibles. However, if we measure the quality of individuals' decisions based on risk preferences, the heterogeneity among participants disappears. Our results suggest that heterogeneity in health insurance choices is not reflected in decision quality when we assume a rank-dependent expected utility model of risk preferences.
    Keywords: health insurance, consumer preferences, heterogeneity, laboratory experiment, risk preferences
    JEL: C91 I13 D81 D83 G22
    Date: 2023
  5. By: Sproule, Robert
    Abstract: Both the Wold-Juréen (1953) utility function and the Wold-Juréen (1953) production function have played a central role in the modelling and the analysis of the Giffen behavior. Using an amalgam of these two functions, this paper defines the Wold-Juréen (1953) functional form, and then compares its properties to the properties of the arbitrary functional form, in an effort to provide a global perspective on the unique nature of the Wold-Juréen (1953) functional form. This paper then reports: (a) that the domain of the Wold-Juréen (1953) functional form (or the first functional form) is a subset of the domain of the arbitrary functional form (or the second functional form), (b) that the signs of the second derivatives of the Wold-Juréen (1953) functional form (or the first functional form) are the opposite of the signs of the second derivatives of the arbitrary functional form (or the second functional form), and (c) that (within the context of the unconstrained-maximization problem) the Wold-Juréen (1953) functional form (or the first functional form) is not concave, whereas the arbitrary functional form (or the second functional form) is concave.
    Keywords: Wold-Juréen (1953) functional form, Arbitrary functional form, Giffen behavior, Consumer theory, Producer theory
    JEL: A22 A23 D11 D21
    Date: 2023–07–05
  6. By: Sabiou Inoua; Vernon Smith
    Abstract: This paper introduces and formalizes the classical view on supply and demand, which, we argue, has an integrity independent and distinct from the neoclassical theory. Demand and supply, before the marginal revolution, are defined not by an unobservable criterion such as a utility function, but by an observable monetary variable, the reservation price: the buyer's (maximum) willingness to pay (WTP) value (a potential price) and the seller's (minimum) willingness to accept (WTA) value (a potential price) at the marketplace. Market demand and supply are the cumulative distribution of the buyers' and sellers' reservation prices, respectively. This WTP-WTA classical view of supply and demand formed the means whereby market participants were motivated in experimental economics although experimentalists (trained in neoclassical economics) were not cognizant of their link to the past. On this foundation was erected a vast literature on the rules of trading for a host of institutions, modern and ancient. This paper documents textually this reappraisal of classical economics and then formalizes it mathematically. A follow-up paper will articulate a theory of market price formation rooted in this classical view on supply and demand and in experimental findings on market behavior.
    Date: 2023–07
  7. By: Alessandro Doldi; Marco Frittelli; Emanuela Rosazza Gianin
    Abstract: Shortfall systemic (multivariate) risk measures $\rho$ defined through an $N$-dimensional multivariate utility function $U$ and random allocations can be represented as classical (one dimensional) shortfall risk measures associated to an explicitly determined $1$-dimensional function constructed from $U$. This finding allows for simplifying the study of several properties of $\rho$, such as dual representations, law invariance and stability.
    Date: 2023–06
  8. By: Massimo Guidolin; Erwin Hansen; Gabriel Cabrera
    Abstract: We estimate an aggregate time-varying risk aversion function using option, stock return and macroeconomic data for a sample of 8 countries. We document that, in most of the countries, the degree of risk aversion is countercyclical. Moreover, we show that the estimated risk aversion function forecasts monthly stock index returns up to 12 months ahead. This effect is statistically significant in panel regressions, and it survives the inclusion of additional control variables. Finally, we show that the estimated time-varying risk aversion function provides useful information to an investor who aims at timing the market. An investment strategy that uses the estimated time-varying risk aversion measure to solve a mean-variance asset allocation problem, delivers significant returns.
    Keywords: Implied risk aversion, forecast stock return, market timing, mean-variance asset allocation.
    JEL: G10 G11 G15
    Date: 2023
  9. By: Marcos Escobar-Anel; Michel Kschonnek; Rudi Zagst
    Abstract: We consider a portfolio optimisation problem for a utility-maximising investor who faces convex constraints on his portfolio allocation in Heston's stochastic volatility model. We apply the duality methods developed in previous work to obtain a closed-form expression for the optimal portfolio allocation. In doing so, we observe that allocation constraints impact the optimal constrained portfolio allocation in a fundamentally different way in Heston's stochastic volatility model than in the Black Scholes model. In particular, the optimal constrained portfolio may be different from the naive capped portfolio, which caps off the optimal unconstrained portfolio at the boundaries of the constraints. Despite this difference, we illustrate by way of a numerical analysis that in most realistic scenarios the capped portfolio leads to slim annual wealth equivalent losses compared to the optimal constrained portfolio. During a financial crisis, however, a capped solution might lead to compelling annual wealth equivalent losses.
    Date: 2023–06
  10. By: Sabiou Inoua; Vernon Smith
    Abstract: In retrospect, the experimental findings on competitive market behavior called for a revival of the old, classical, view of competition as a collective higgling and bargaining process (as opposed to price-taking behaviors) founded on reservation prices (in place of the utility function). In this paper, we specialize the classical methodology to deal with speculation, an important impediment to price stability. The model involves typical features of a field or lab asset market setup and lends itself to an experimental test of its specific predictions; here we use the model to explain three general stylized facts, well established both empirically and experimentally: the excess, fat-tailed, and clustered volatility of speculative asset prices. The fat tails emerge in the model from the amplifying nature of speculation, leading to a random-coefficient autoregressive return process (and power-law tails); the volatility clustering is due to the traders' long memory of news; bubbles are a persistent phenomenon in the model, and, assuming the standard lab present value pattern, the bubble size increases with the proportion of speculators and decreases with the trading horizon.
    Date: 2023–07
  11. By: Guru Guruganesh; Jon Schneider; Joshua Wang; Junyao Zhao
    Abstract: We study the power of menus of contracts in principal-agent problems with adverse selection (agents can be one of several types) and moral hazard (we cannot observe agent actions directly). For principal-agent problems with $T$ types and $n$ actions, we show that the best menu of contracts can obtain a factor $\Omega(\max(n, \log T))$ more utility for the principal than the best individual contract, partially resolving an open question of Guruganesh et al. (2021). We then turn our attention to randomized menus of linear contracts, where we likewise show that randomized linear menus can be $\Omega(T)$ better than the best single linear contract. As a corollary, we show this implies an analogous gap between deterministic menus of (general) contracts and randomized menus of contracts (as introduced by Castiglioni et al. (2022)).
    Date: 2023–06
  12. By: Daron Acemoglu; Alireza Fallah; Ali Makhdoumi; Azarakhsh Malekian; Asuman Ozdaglar
    Abstract: Many platforms deploy data collected from users for a multitude of purposes. While some are beneficial to users, others are costly to their privacy. The presence of these privacy costs means that platforms may need to provide guarantees about how and to what extent user data will be harvested for activities such as targeted ads, individualized pricing, and sales to third parties. In this paper, we build a multi-stage model in which users decide whether to share their data based on privacy guarantees. We first introduce a novel mask-shuffle mechanism and prove it is Pareto optimal—meaning that it leaks the least about the users’ data for any given leakage about the underlying common parameter. We then show that under any mask-shuffle mechanism, there exists a unique equilibrium in which privacy guarantees balance privacy costs and utility gains from the pooling of user data for purposes such as assessment of health risks or product development. Paradoxically, we show that as users’ value of pooled data increases, the equilibrium of the game leads to lower user welfare. This is because platforms take advantage of this change to reduce privacy guarantees so much that user utility declines (whereas it would have increased with a given mechanism). Even more strikingly, we show that platforms have incentives to choose data architectures that systematically differ from those that are optimal from the user’s point of view. In particular, we identify a class of pivot mechanisms, linking individual privacy to choices by others, which platforms prefer to implement and which make users significantly worse off.
    JEL: D62 D83 L86
    Date: 2023–06
  13. By: Daniel Reck; Arthur Seibold
    Abstract: Empirical evidence suggests that individuals often evaluate options relative to a reference point, especially seeking to avoid losses. We undertake the first welfare analysis under reference-dependent preferences. We characterize the welfare impact of changes in reference points and prices, decomposing these into direct and behavioral effects. The sign of direct and behavioral effects depends on the form of reference-dependent payoffs; which of these effects matter for welfare depends on whether reference dependence reflects a bias or a normative preference. We derive sufficient statistics formulas quantifying the social welfare effects of changes in reference points and prices in terms of estimable reduced-form parameters and normative judgments. We illustrate these findings with an empirical application to reference dependence exhibited in German workers' retirement decisions. We find positive social welfare effects of increasing the Normal Retirement Age, but ambiguous effects of financial incentives to postpone retirement.
    JEL: D60 D90 H55
    Date: 2023–06
  14. By: Genakos, C.; Roumanias, C.; Valletti, T.
    Abstract: We present novel evidence from a large panel of UK consumers who receive personalized reminders from a specialist price-comparison website about the precise amount they could save by switching to their best-suited alternative mobile telephony plan. We document three phenomena. First, even self-registered consumers with positive savings exhibit inertia. Second, we show that being informed about potential savings has a positive and significant effect on switching. Third, controlling for savings, the effect of incurring overage payments is significant and similar in magnitude to the effect of savings: paying an amount that exceeds the recurrent monthly fee weighs more on the switching decision than being informed that one can save that same amount by switching to a less inclusive plan. We interpret this asymmetric reaction on switching behavior as potential evidence of loss aversion. In other words, when facing complex and recurrent tariff plan choices, consumers care about savings but also seem to be willing to pay upfront fees in order to get “peace of mind†.
    Keywords: tariff/plan choice, inertia, switching, loss aversion, mobile telephony
    JEL: D91 D12 D81 L96 M30
    Date: 2023–07–11

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