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on Utility Models and Prospect Theory |
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Issue of 2023‒09‒25
thirteen papers chosen by |
| By: | Chiaki Hara (Institute of Economic Research, Kyoto University) |
| Abstract: | We define a measure of ambiguity aversion for ambiguity-averse utility functions in a way analogous to the Arrow-Pratt measure of risk aversion. The measure is determined by the second Peano derivative, which exists even for non-differentiable functions, such as maximin and Choquet expected utility functions. Unlike the standard notion of comparative ambiguity aversion, it allows us to compare ambiguity aversion between two utility functions exhibiting different risk attitudes. We introduce a notion of ambiguity premium and show that our measure is related to the second-order, as opposed to the first-order, ambiguity premium. We also show that it is related to the first-order impact on matching probabilities of the size of prizes. |
| Keywords: | Expected utility functions, risk aversion, ambiguity aversion, ambiguity premium, matching probabilities, Peano derivative |
| JEL: | C38 D81 G11 |
| Date: | 2023–09 |
| URL: | http://d.repec.org/n?u=RePEc:kyo:wpaper:1097&r=upt |
| By: | James Roumasset (University of Hawaii Manoa) |
| Abstract: | As Richard Day explained, expected utility theory suffers from procedural irrationality. This and other problems are illustrated here in the context of decision-making among low-income farmers. Farmers in developing countries are commonly thought to underinvest in modern techniques because their low incomes make them especially risk averse. In addition to the procedural leap of faith, highly restrictive assumptions are needed to apply expected utility theory to the problem. Nor does expected utility theory, as usually prescribed, fit the narrative of loss aversion. The reader is introduced to a procedurally rational substitute called lexicographic safety first. The model is illustrated for the case of rice fertilization in the Philippines, and policy implications are drawn. To illustrate the potential appeal of lexicographic ordering for other applications involving thresholds, a lexicographic model of rational addiction is also provided. |
| Keywords: | technology adoption, agricultural development, risk, subsistence, satisficing |
| JEL: | D21 D81 O33 Q16 |
| Date: | 2023–09 |
| URL: | http://d.repec.org/n?u=RePEc:hai:wpaper:202306&r=upt |
| 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) |
| Abstract: | Basic numeracy skills are obviously important for rational decisionmaking when agents are facing choices between risky prospects. Poor and vulnerable people with limited education and numeracy skills live in risky environments and have to make rational decisions in order to survive. How capable are they to understand and respond rationally to economists’ tools for the elicitation of risk preferences? Can we make designs that are simple enough for them to give rational responses that reveal their true preferences? And how much does variation in their limited numeracy skills contribute to decision errors and the estimated sizes of their risk preference parameters? Finally, we ask whether Expected Utility (EU) theory is sufficient or whether Rank Dependent Utility (RDU) does better in the analysis of decision errors and risk preferences in our context. We try to answer these research questions based on a large sample of rural youth business group members from Ethiopia based on two variants of a Certainty Equivalent - Multiple Choice List (CE-MCL) approach with 12 and 10 Choice Lists (CLs) per subject. Numeracy skill scores are constructed based on a math test with 15 contextualized questions. The experiment facilitates the estimation of structural models while separating the effects of numeracy skills on decision errors in a Fechner error specification that is a function of numeracy skills and experimental design characteristics. The structural models estimate alternatively Expected Utility (EU) and Rank Dependent Utility (RDU) models, the latter with two-parameter Prelec probability weighting functions.It allows us to assess whether limited numeracy skills are correlated with EU-type risk tolerance (utility curvature) and RDU-type of probabilistic risk tolerance in the form of probabilistic insensitivity and optimism/pessimism bias. We find that weak numeracy skills are associated with slightly less risk tolerance in EU models, with stronger probabilistic insensitivity in RDU models, and with more random noise (Fechner error) in both types of models. However, even the subjects with the weakest numeracy skills performed quite well in the simple CE-MCL experiments with the binary choice elicitation approach, indicating that it was capable of revealing the risk preferences of such subjects with very low numeracy skills as they produced only marginally more decision errors than subjects with better numeracy skills. |
| Keywords: | Numeracy skills; Risk preferences; Field experiment; Ethiopia |
| JEL: | C93 D81 |
| Date: | 2023–09–15 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:nlsclt:2023_005&r=upt |
| By: | René van den Brink (VU University Amsterdam and Tinbergen Institute); Agnieszka Rusinowska (CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, CNRS - Centre National de la Recherche Scientifique, UP1 - Université Paris 1 Panthéon-Sorbonne, PSE - Paris School of Economics - UP1 - Université Paris 1 Panthéon-Sorbonne - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris sciences et lettres - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement) |
| Abstract: | This paper aims to connect the social network literature on centrality measures with the economic literature on von Neumann-Morgenstern expected utility functions using cooperative game theory. The social network literature studies various concepts of network centrality, such as degree, betweenness, connectedness, and so on. This resulted in a great number of network centrality measures, each measuring centrality in a different way. In this paper, we aim to explore which centrality measures can be supported as von Neumann-Morgenstern expected utility functions, reflecting preferences over different network positions in different networks. Besides standard axioms on lotteries and preference relations, we consider neutrality to ordinary risk. We show that this leads to a class of centrality measures that is fully determined by the degrees (i.e. the numbers of neighbours) of the positions in a network. Although this allows for externalities, in the sense that the preferences of a position might depend on the way how other positions are connected, these externalities can be taken into account only by considering the degrees of the network positions. Besides bilateral networks, we extend our result to general cooperative TU-games to give a utility foundation of a class of TU-game solutions containing the Shapley value. |
| Keywords: | weighted network, degree, centrality measure, externalities, neutrality to ordinary risk, expected utility function |
| Date: | 2023–08 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-04188289&r=upt |
| By: | Emma Kroell; Sebastian Jaimungal; Silvana M. Pesenti |
| Abstract: | We study a reinsurer who faces multiple sources of model uncertainty. The reinsurer offers contracts to $n$ insurers whose claims follow different compound Poisson processes. As the reinsurer is uncertain about the insurers' claim severity distributions and frequencies, they design reinsurance contracts that maximise their expected wealth subject to an entropy penalty. Insurers meanwhile seek to maximise their expected utility without ambiguity. We solve this continuous-time Stackelberg game for general reinsurance contracts and find that the reinsurer prices under a distortion of the barycentre of the insurers' models. We apply our results to proportional reinsurance and excess-of-loss reinsurance contracts, and illustrate the solutions numerically. Furthermore, we solve the related problem where the reinsurer maximises, still under ambiguity, their expected utility and compare the solutions. |
| Date: | 2023–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2308.11828&r=upt |
| By: | Glötzl, Erhard; Glötzl, Florentin; Richters, Oliver; Binter, Lucas |
| Abstract: | For more than 100 years economists have tried to describe economics in analogy to physics, more precisely to classical Newtonian mechanics. The development of the Neoclassical General Equilibrium Theory has to be understood as the result of these efforts. But there are many reasons why General Equilibrium Theory is inadequate: 1. No genuine dynamics. 2. The assumption of the existence of utility functions and the possibility to aggregate them to one “master” utility function. 3. The impossibility to describe situations as in “Prisoners Dilemma”, where individual optimization does not lead to a collective optimum. This book aims at overcoming these problems. It illustrates how not only equilibria of economic systems, but also the general dynamics of these systems can be described in close analogy to classical mechanics. To this end, this book makes the case for an approach based on the concept of constrained dynamics, analyzing the economy from the perspective of “economic forces” and “economic power” based on the concept of physical forces and the reciprocal value of mass. Realizing that accounting identities constitute constraints in the economy, the concept of constrained dynamics, which is part of the standard models of classical mechanics, can be applied to economics. Therefore, it is reasonable to denote such models as General Constraint Dynamic Models (GCD-Models) Such a framework allows understanding both Keynesian and neoclassical models as special cases of GCD-Models in which the power relationships with respect to certain variables are one-sided. As mixed power relationships occur more frequently in reality than purely one-sided power constellations, GCD-models are better suited to describe the economy than standard Keynesian or Neoclassic models. A GCD-model can be understood as “Continuous Time”, “Stock Flow Consistent”, “Microfounded”, where the behaviour of the agents is described with a general differential equation for every agent. In the special case where the differential equations can be described with utility functions, the behaviour of every agent can be understood as an individual optimization strategy. He thus seeks to maximize his utility. However, while the core assumption of neoclassical models is that due to the “invisible hand” such egoistic individual behaviour leads to an optimal result for all agents, reality is often defined by “Prisoners Dilemma” situations, in which individual optimization leads to the worst outcome for all. One advantage of GCD-models over standard models is that they are able to describe also such situations, where an individual optimization strategy does not lead to an optimum result for all agents. In conclusion, the big merit and effort of Newton was, to formalize the right terms (physical force, inertial mass, change of velocity) and to set them into the right relation. Analogously the appropriate terms of economics are economic force, economic power and change of variables. GCD-Models allow formalizing them and setting them into the right relation to each other. |
| Keywords: | Stephen Smale, Problem 8, macroeconomic models, constraint dynamics, GCD, DSGE, out-of-equilibrium dynamics, Lagrangian mechanics, stock flow consistent, SFC, demand shock, supply shock, price shock, intertemporal utility function |
| JEL: | A12 B13 B41 B59 C02 C30 C54 C60 E10 |
| Date: | 2023–06–01 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:118314&r=upt |
| By: | Cigno, Alessandro |
| Abstract: | Basu and Van (1998) show that a ban on child labour may be self-enforcing if, above the subsistence level, no amount of consumption can compensate parents for the disutility of child labour. We show that a partial ban may be self-enforcing, but a total one never is, if education is available, and the disutility of child labour can be compensated by the expected utility of future consumption. If some of the work children do is not observable by the government, a ban may be only apparently self-enforcing, or actually counterproductive. If the government wants to re- duce child labour and raise education to the effi cient level, it can borrow from the international credit market to subsidize parents, and tax their children's future wages to pay the loan back with interests. |
| Keywords: | Child labour, education, self-enforcing ban, norms |
| JEL: | H31 J22 O12 |
| Date: | 2023 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:glodps:1325&r=upt |
| By: | Francesco Menoncin; Andrea Modena; Luca Regis |
| Abstract: | We study tax evasion in a dynamic macroeconomic model where utility-maximizing entrepreneurs use capital to produce or buy bonds, depending on their firm’s stochastic productivity. The government provides productivity-enhancing public goods financed through taxes and bond issuance. Entrepreneurs can increase their income by evading taxes at the risk of being audited and fined. Lower productivity boosts evasion incentives, exacerbating capital misallocation because unproductive entrepreneurs accumulate wealth at their peers’ expense. Consistently with OECD data, the model predicts a negative relation between tax evasion and productivity in the aggregate but heterogeneous signs and magnitudes across productivities. Public goods provision affects these outcomes ambiguously. |
| Keywords: | dynamic tax evasion, financial frictions, general equilibrium, misallocation |
| JEL: | E25 E26 H23 H26 |
| Date: | 2023–08 |
| URL: | http://d.repec.org/n?u=RePEc:bon:boncrc:crctr224_2023_453&r=upt |
| By: | HyeonJun Kim |
| Abstract: | This study explores the potential of internet search volume data, specifically Google Trends, as an indicator for cross-sectional stock returns. Unlike previous studies, our research specifically investigates the search volume of the topic 'happiness' and its impact on stock returns in the aspect of risk pricing rather than as sentiment measurement. Empirical results indicate that this 'happiness' search exposure (HSE) can explain future returns, particularly for big and value firms. This suggests that HSE might be a reflection of a firm's ability to produce goods or services that meet societal utility needs. Our findings have significant implications for institutional investors seeking to leverage HSE-based strategies for outperformance. Additionally, our research suggests that, when selected judiciously, some search topics on Google Trends can be related to risks that impact stock prices. |
| Date: | 2023–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2308.10039&r=upt |
| By: | Ylenia Brilli (Department of Economics, University Of Venice CÃ Foscari); Simone Moriconi (IESEG School of Management, Univ. Lille, CNRS, UMR 9221 - LEM - Lille Economie Management, F-59000 Lille, France; CESIfo Munich; Institut Convergences Migrations) |
| Abstract: | This paper analyzes how a cultural trait that values “engagement†in child-rearing activities affects the choice of parents concerning parental investments and labor supply. We use data from the World Value Survey to construct a country-specific measure of parental engagement, which we associate with the time investments in children of first- and second-generation migrants in Australia. We show that migrant parents from more engaged cultures increase their time investment during weekends, in particular in play activities, while spending less time with their children during working days. We also show that these parents are more affectionate and are more likely to discipline the children and to reason about their children’s misbehavior than individuals from less engaged cultures. Finally, we provide evidence that culture specific parental engagement features a more egalitarian allocation of parenting vs. labor supply tasks by the couple. We interpret this as indirect evidence that fathers may have a greater marginal utility from parenting time than mothers, on average. |
| Keywords: | culture, parental investments, parenting, labor supply |
| JEL: | D10 J13 J15 J22 Z13 |
| Date: | 2023 |
| URL: | http://d.repec.org/n?u=RePEc:ven:wpaper:2023:17&r=upt |
| By: | Daniel Gallardo-Albarrán (Wageningen University) |
| Abstract: | This article reviews the proximate factors of human welfare since 1870 by discussing two strands of the economic history literature and identifying various key areas for further research. The first strand focuses on level accounting studies that attribute between-country economic inequality to differences in capital and productivity. I argue that most income gaps in the late 19th century were due to variation in physical and human capital endowments, while widening productivity differentials account for most of rising cross-country inequality during the 20th century. These patterns are likely explained by waves of skill- and capital- biased technological innovation, but additional research is needed to underpin these findings in, at least, three ways: capital and income series should be deflated by appropriate price indices, samples should include many more lower-income countries and methodologies could explore more realistic production functions. The second strand of the literature I review considers the measurement of long-run human development. Three approaches are popular among practitioners (capability, data-driven and utility frameworks), although there is still no consensus on which one to use. This makes it challenging to interpret broad trends in human welfare, as different well-being indices show contrasting patterns of growth and inequality. I argue that the field needs a more solid theoretical foundation to guide our choice of measurement frameworks. In this respect, utility-based indicators may be especially useful, as they address relevant issues raised in the literature, such as how to weight different dimensions, how individuals trade off between them, and how to interpret the results. |
| Keywords: | capital, productivity, human development, well-being, economic history |
| JEL: | I31 N00 N10 N30 O47 |
| Date: | 2023–08 |
| URL: | http://d.repec.org/n?u=RePEc:hes:wpaper:0237&r=upt |
| By: | Cary Frydman; Lawrence J. Jin |
| Abstract: | We propose and experimentally test a new theory of probability distortions in risky choice. The theory is based on a core principle from neuroscience called efficient coding, which states that information is encoded more accurately for those stimuli that the agent expects to encounter more frequently. As the agent's prior beliefs vary, the model predicts that probability distortions change systematically. We provide novel experimental evidence consistent with the prediction: lottery valuations are more sensitive to probabilities that occur more frequently under the subject's prior beliefs. Our theory generates additional novel predictions regarding heterogeneity and time variation in probability distortions. |
| JEL: | D03 G02 G41 |
| Date: | 2023–08 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:31573&r=upt |
| By: | Brice Corgnet (emlyon business school, GATE UMR 5824, F-69130 Ecully, France); Roberto Hernán González (CEREN EA 7477, Burgundy School of Business, Université Bourgogne Franche-Comté, Dijon, France) |
| Abstract: | Recent works have emphasized the role of complexity as a critical constraint on human behavior following Herbert Simon’s original proposal (complexity-cost hypothesis). By contrast, we propose, in line with recent neuroscience models, that complexity can often be appealing (complexity-value hypothesis). Complexity can attract decision makers because it is associated with a large diversity of outcomes, thus offering many opportunities for the resolution of uncertainty, which is inherently appealing to humans. Using incentivized experiments, we show that, in the absence of immediate feedback on lottery outcomes, decision makers prefer lotteries with less outcomes (low-entropy) in line with the complexity-cost hypothesis. However, when feedback is provided and opportunities for resolving uncertainty are thus offered, this effect disappears in line with the complexity-value hypothesis. We discuss various implications of these findings in human resource management, marketing, and finance. |
| Keywords: | Complexity, entropy, experiments |
| JEL: | C91 D01 D81 D87 |
| Date: | 2023 |
| URL: | http://d.repec.org/n?u=RePEc:gat:wpaper:2312&r=upt |