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on Utility Models and Prospect Theory |
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Issue of 2024‒02‒19
twenty papers chosen by |
| By: | Luca De Gennaro Aquino; Xuedong He; Moris Simon Strub; Yuting Yang |
| Abstract: | We study a discrete-time consumption-based capital asset pricing model under expectations-based reference-dependent preferences. More precisely, we consider an endowment economy populated by a representative agent who derives utility from current consumption and from gains and losses in consumption with respect to a forward-looking, stochastic reference point. First, we consider a general model in which the agent's preferences include both contemporaneous gain-loss utility, that is, utility from the difference between current consumption and previously held expectations about current consumption, and prospective gain-loss utility, that is, utility from the difference between intertemporal beliefs about future consumption. A semi-closed form solution for equilibrium asset prices is derived for this case. We then specialize to a model in which the agent derives contemporaneous gain-loss utility only, obtaining equilibrium asset prices in closed form. Extensive numerical experiments show that, with plausible values of risk aversion and loss aversion, our models can generate equity premia that match empirical estimates. Interestingly, the models turn out to be consistent with some well-known empirical facts, namely procyclical variation in the price-dividend ratio and countercyclical variation in the conditional expected equity premium and in the conditional volatility of the equity premium. Furthermore, we find that prospective gain-loss utility is necessary for the model to predict reasonable values of the price-dividend ratio. |
| Date: | 2024–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2401.12856&r=upt |
| By: | Jeongbin Kim; Matthew Kovach; Kyu-Min Lee; Euncheol Shin; Hector Tzavellas |
| Abstract: | This paper explores the use of Large Language Models (LLMs) as decision aids, with a focus on their ability to learn preferences and provide personalized recommendations. To establish a baseline, we replicate standard economic experiments on choice under risk (Choi et al., 2007) with GPT, one of the most prominent LLMs, prompted to respond as (i) a human decision maker or (ii) a recommendation system for customers. With these baselines established, GPT is provided with a sample set of choices and prompted to make recommendations based on the provided data. From the data generated by GPT, we identify its (revealed) preferences and explore its ability to learn from data. Our analysis yields three results. First, GPT's choices are consistent with (expected) utility maximization theory. Second, GPT can align its recommendations with people's risk aversion, by recommending less risky portfolios to more risk-averse decision makers, highlighting GPT's potential as a personalized decision aid. Third, however, GPT demonstrates limited alignment when it comes to disappointment aversion. |
| Date: | 2024–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2401.07345&r=upt |
| By: | Wenyuan Wang; Kaixin Yan; Xiang Yu |
| Abstract: | This paper studies a type of periodic utility maximization for portfolio management in an incomplete market model, where the underlying price diffusion process depends on some external stochastic factors. The portfolio performance is periodically evaluated on the relative ratio of two adjacent wealth levels over an infinite horizon. For both power and logarithmic utilities, we formulate the auxiliary one-period optimization problems with modified utility functions, for which we develop the martingale duality approach to establish the existence of the optimal portfolio processes and the dual minimizers can be identified as the "least favorable" completion of the market. With the help of the duality results in the auxiliary problems and some fixed point arguments, we further derive and verify the optimal portfolio processes in a periodic manner for the original periodic evaluation problems over an infinite horizon. |
| Date: | 2024–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2401.14672&r=upt |
| By: | Brian Hill (HEC Paris - Recherche - Hors Laboratoire - HEC Paris - Ecole des Hautes Etudes Commerciales, CNRS - Centre National de la Recherche Scientifique, GREGH - Groupement de Recherche et d'Etudes en Gestion à HEC - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique) |
| Abstract: | Although much of the theoretical and applied literature involving decision under ambiguity works under the assumption of uncertainty aversion, experimental evidence suggests that it is not a universal behavioural trait. This paper introduces and axiomatises the family of α-UA (for α-Uncertainty Attitude) preferences: a simple extension of uncertainty averse preferences with a Hurwicz-style mixing coefficient, so as to admit a richer range of uncertainty attitudes. The parameters of the model are uniquely identified in our characterisation. It provides, in the Hurwicz α-maxmin EU special case, a new resolution of a long-standing identification problem. It also yields novel models, including extensions of variational and multiplier preferences. Comparative statics support the interpretation of the mixing coefficient as an index of imprecision aversion. In a standard portfolio problem, the model yields the intuitive relationship between imprecision aversion and investment in an uncertain asset: as the former increases, the latter decreases. |
| Keywords: | Decision under uncertainty, Ambiguity, Uncertainty aversion, Imprecision attitude, Objective imprecision, Multiple priors, α-maxmin EU, Multiplier preferences |
| Date: | 2023–09 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-02428398&r=upt |
| By: | Emmanuel Kemel (GREGHEC - Groupement de Recherche et d'Etudes en Gestion - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique); Corina Paraschiv (LIRAES (URP_ 4470) - Laboratoire Interdisciplinaire de Recherche Appliquée en Economie de la Santé - UPCité - Université Paris Cité) |
| Abstract: | This paper presents an experiment that investigates differences in risk attitudes in decisions with immediate versus delayed consequences. Our experimental design allows to control for the effects of discounting and timing of risk resolution. We show that individuals are more risk tolerant in situations involving delayed consequences. Investigations based on rank-dependent utility show that this finding is mainly driven by probability weighting. More precisely, probability weighting is more elevated for delayed consequences. This suggests an overall increase in decision-makers' optimism regarding the chances of success when consequences materialize in the future. |
| Keywords: | Risk Attitudes, Time, Rank Dependent Utility, Delay, Future Consequences |
| Date: | 2023–04 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-04385738&r=upt |
| By: | Ilke Aydogan (IÉSEG School Of Management [Puteaux]); Loïc Berger (CNRS - Centre National de la Recherche Scientifique, IÉSEG School Of Management [Puteaux], EIEE - European Institute on Economics and the Environment, CMCC - Centro Euro-Mediterraneo per i Cambiamenti Climatici [Bologna]); Valentina Bosetti (Bocconi University [Milan, Italy], EIEE - European Institute on Economics and the Environment, CMCC - Centro Euro-Mediterraneo per i Cambiamenti Climatici [Bologna]) |
| Abstract: | We report the results of two experiments designed to better understand the mechanisms driving decision-making under ambiguity. We elicit individual preferences over different sources of uncertainty (risk, compound risk, model ambiguity, and Ellsberg ambiguity), which entail different degrees of complexity, from subjects with different sophistication levels. We show that (1) ambiguity aversion is robust to sophistication, but the strong relationship that has been previously reported between attitudes toward ambiguity and compound risk is not. (2) Ellsberg ambiguity attitude can be partly explained by attitudes toward complexity for less sophisticated subjects, but not for more sophisticated ones. Overall, and regardless of the subject's sophistication level, the main driver of Ellsberg ambiguity attitude is a specific treatment of unknown probabilities. These results leave room for using ambiguity models in applications with prescriptive purposes. |
| Keywords: | Ambiguity aversion, complexity, reduction of compound risk, model uncertainty |
| Date: | 2023–01 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-04071242&r=upt |
| By: | Fangzhi Wang; Hua Liao; Richard S.J. Tol (Department of Economics, University of Sussex, BN1 9SL Falmer, United Kingdom) |
| Abstract: | Carbon abatement decisions are usually based on the implausible assumption of constant social preference. This paper focuses on a specific case of market and non-market goods, and investigates the optimal climate policy when social preference for them is also changed by climate policy in the DICE model. The relative price of non-market goods grows over time due to increases in both relative scarcity and appreciation of it. Therefore, climbing relative price brings upward the social cost of carbon denominated in terms of market goods. Because abatement decision affects the valuation of non-market goods in the utility function, unlike previous climate-economy models, we solve the model iteratively by taking the obtained abatement rates from the last run as inputs in the current run. The results in baseline calibration advocate a more stringent climate policy, where endogenous social preference to climate policy raises the social cost of carbon further by roughly 12%-18% this century. Moreover, neglecting changing social preference leads to an underestimate of non-market goods damages by 15%. Our results support that climate policy is self-reinforced if it favors more expensive consumption type. |
| Keywords: | climate change; optimal emission control; endogenous preferences |
| JEL: | Q54 |
| Date: | 2024–01 |
| URL: | http://d.repec.org/n?u=RePEc:sus:susewp:0224&r=upt |
| By: | Houda Nait El Barj; Theophile Sautory |
| Abstract: | We study the dynamics of opinions in a setting where a leader has a payoff that depends on agents' beliefs and where agents derive psychological utility from their beliefs. Agents sample a signal that maximises their utility and then communicate with each other through a network formed by disjoint social groups. The leader has a choice to target a finite set of social groups with a specific signal to influence their beliefs and maximise his returns. Heterogeneity in agents' preferences allows us to analyse the evolution of opinions as a dynamical system with asymmetric forces. We apply our model to explain the emergence of hatred and the spread of racism in a society. We show that when information is restricted, the equilibrium level of hatred is determined solely by the belief of the most extremist agent in the group regardless of the inherent structure of the network. On the contrary, when information is dense, the space is completely polarised in equilibrium with the presence of multiple "local truths" which oscillate in periodic cycles. We find that when preferences are uniformly distributed, the equilibrium level of hatred depends solely on the value of the practical punishment associated with holding a hate belief. Our finding suggests that an optimal policy to reduce hatred should focus on increasing the cost associated with holding a racist belief. |
| Date: | 2024–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2401.07178&r=upt |
| By: | Genakos, Christos; Roumanias, Costas; Valletti, Tommaso |
| 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: | 2023–07–25 |
| URL: | http://d.repec.org/n?u=RePEc:ehl:lserod:121294&r=upt |
| By: | Ferreira, Susana (University of Georgia); Martinez-de-Morentin, Sara (Universidad Pública de Navarra); Erro-Garcés, Amaya (Universidad Pública de Navarra) |
| Abstract: | Hedonic wage regressions show little evidence that European workers facing larger job risks and other workplace disamenities receive higher wages. On the other hand, workers in more risky or unpleasant jobs are less satisfied with their jobs, ceteris paribus. If labor markets were perfectly competitive and workers fully informed of their working conditions ex ante, according to the theory of compensating differentials, there should be no relationship between on-the-job risk and job satisfaction because wages would fully adjust to compensate for differences in job characteristics. We show that when wages do not fully compensate for on-the-job risks, the willingness to pay to reduce mortality risks estimated from hedonic regressions needs to be complemented with a residual effect of job risks on utility which is not capitalized on wages. We explore the potential of job satisfaction regressions as an additional valuation approach to estimate the tradeoffs between wages and risks that keep job satisfaction constant. |
| Keywords: | on-the-job risk, experienced preference, job satisfaction, hedonic wages, stated preference, value of a statistical life |
| JEL: | Q51 I12 I18 J17 J31 K32 |
| Date: | 2024–01 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp16716&r=upt |
| By: | Mitra, Manipushpak (Economic Research Unit, Indian Statistical Institute); Ray, Indrajit (Cardiff Business School, Cardiff University); Roy, Souvik (Applied Statistics Unit, Indian Statistical Institute) |
| Abstract: | For a strategic market game (as introduced by Shapley and Shubik), following Dubey and Rogawski (1990), we provide a full explicit characterisation of the set of trading equilibria (in which all goods are traded at a positive price), for both the “buy and sell†and the “buy or sell†versions of this model under standard assumptions on the utility functions. We interpret and illustrate our equilibrium-characterising conditions; we also provide simple examples of trading equilibria, including those of non-interior strategy profiles (in which at least one trader is using the whole endowment in at least one good or money). |
| Keywords: | strategic market game ; trading equilibrium ; interior profile ; buy and sell ; buy or sell JEL codes: C72 ; D44 |
| Date: | 2024 |
| URL: | http://d.repec.org/n?u=RePEc:wrk:wcreta:83&r=upt |
| By: | Ludwig von Auer |
| Abstract: | A chained price index is said to suffer from chain drift bias if it indicates an overall price change, even though the prices and quantities in the current period have reverted back to their levels of the base period. The empirical relevance of this bias is well documented in studies that apply sub-annual chaining to scanner data. There it is shown that stockpiling can lead to downward chain drift bias. The present paper draws attention to the fact that smoothing consumption causes substantial upward chain drift. In addition, this study introduces a simple utility framework consistent with stockpiling and smoothing. Building on this framework, a "stress test" is conducted that examines whether rolling window variants of multilateral indices (GEKS, TPD, and GK) effectively curtail the chain drift problem. |
| Date: | 2024 |
| URL: | http://d.repec.org/n?u=RePEc:trr:wpaper:202402&r=upt |
| By: | Yann Braouezec (LEM - Lille économie management - UMR 9221 - UA - Université d'Artois - UCL - Université catholique de Lille - Université de Lille - CNRS - Centre National de la Recherche Scientifique, IÉSEG School Of Management [Puteaux]); John Cagnol (FR3487 - Fédération de Mathématiques de CentraleSupélec - CentraleSupélec - Université Paris-Saclay - CNRS - Centre National de la Recherche Scientifique, MICS - Mathématiques et Informatique pour la Complexité et les Systèmes - CentraleSupélec - Université Paris-Saclay) |
| Abstract: | We provide a comprehensive analysis of the two-parameter Beta distributions seen from the perspective of second-order stochastic dominance. By changing its parameters through a bijective mapping, we work with a bounded subset D instead of an unbounded plane. We show that a mean-preserving spread is equivalent to an increase of the variance, which means that higher moments are irrelevant to compare the riskiness of Beta distributions. We then derive the lattice structure induced by second-order stochastic dominance, which is feasible thanks to the topological closure of D. Finally, we consider a standard (expected-utility based) portfolio optimization problem in which its inputs are the parameters of the Beta distribution. We explicitly characterize the subset of D for which the optimal solution consists of investing 100% of the wealth in the risky asset and we provide an exhaustive numerical analysis of this optimal solution through (color-coded) graphs. |
| Keywords: | Beta distribution, secondorder stochastic dominance, topological closure, lattice structure and Hasse diagram, portfolio choices and exhaustive numerical analysis, Risk analysis |
| Date: | 2023 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-04373020&r=upt |
| By: | Balcombe, Kelvin; Fraser, Iain |
| Abstract: | e introduce an alternative approach to lottery prospects experimental design aimed at collecting experimental data for parametric estimation of the cumulative form of Prospect Theory (PT). Our approach incorporates two fundamental principles: ensuring that all tasks provide valuable information and avoiding redundancy among tasks. These principles mean that we avoid the construction of lottery prospects that duplicate information within the set of tasks generated. The methodological approach that we have designed ensures that each lottery pair is non-redundant in an informational sense. This means that the set of lottery tasks generated can help to improve the effectiveness of data collection when estimation of preference parameters is the main research objective. In this note, we describe our approach to experimental design in detail. |
| Keywords: | Experimental Design; Lotteries; Risk and Uncertainty; Prospect Theory. |
| JEL: | C52 C90 D81 |
| Date: | 2024–01 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:119743&r=upt |
| By: | David Echeverry Pérez, María Cristina Figueroa, Sandra Polanía-Reyes. |
| Keywords: | Reciprocity, altruism, inequity aversion, latent class models, policy intervention. |
| JEL: | C51 C93 D63 H41 Q20 |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:nva:unnvaa:wp02-2023&r=upt |
| By: | Ilke Aydogan (IÉSEG School Of Management [Puteaux]); Loïc Berger (CNRS - Centre National de la Recherche Scientifique, IÉSEG School Of Management [Puteaux], EIEE - European Institute on Economics and the Environment, CMCC - Centro Euro-Mediterraneo per i Cambiamenti Climatici [Bologna]); Valentina Bosetti (Bocconi University [Milan, Italy], EIEE - European Institute on Economics and the Environment, CMCC - Centro Euro-Mediterraneo per i Cambiamenti Climatici [Bologna]); Ning Liu (BUAA - Beihang University) |
| Abstract: | We explore decision-making under uncertainty using a framework that decomposes uncertainty into three distinct layers: (1) risk, which entails inherent randomness within a given probability model; (2) model ambiguity, which entails uncertainty about the probability model to be used; and (3) model misspecification, which entails uncertainty about the presence of the correct probability model among the set of models considered. Using a new experimental design, we isolate and measure attitudes toward each layer separately. We conduct our experiment on three different subject pools and document, the existence of a behavioral distinction between the three layers. In addition to |
| Date: | 2023–03–27 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-04370968&r=upt |
| By: | Subhamon Supantha; Naresh Kumar Sharma |
| Abstract: | We have used agent-based modeling as our numerical method to artificially simulate a dynamic real economy where agents are rational maximizers of an objective function of Cobb-Douglas type. The economy is characterised by heterogeneous agents, acting out of local or imperfect information, monopolistic competition, perfect product differentiation, allowance for increasing returns to scale technology and trade in disequilibrium. An algorithm for economic activity in each period is devised and a general purpose open source agent-based model is developed which allows for counterfactual inquiries, testing out treatments, analysing causality of various economic processes, outcomes and studying emergent properties. 10, 000 simulations, with 10 firms and 80 consumers are run with varying parameters and the results show that from only a few initial conditions the economy reaches equilibrium while in most of the other cases it remains in perpetual disequilibrium. It also shows that from a few initial conditions the economy reaches a disaster where all the consumer wealth falls to zero or only a single producer remains. Furthermore, from some initial conditions, an ideal economy with high wage rate, high consumer utility and no unemployment is also reached. It was also observed that starting from an equal endowment of wealth in consumers and in producers, inequality emerged in the economy. In majority of the cases most of the firms(6-7) shut down because they were not profitable enough and only a few firms remained. Our results highlight that all these varying outcomes are possible for a decentralized market economy with rational optimizing agents. |
| Date: | 2024–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2401.07070&r=upt |
| By: | Badarinza, Cristian (National University of Singapore); Ramadorai, Tarun (Imperial College Business School and CEPR); Siljander, Juhana (Imperial College Business School); Tripathy, Jagdish (Bank of England) |
| Abstract: | We study the aggregate implications of reference dependent and loss averse preferences in the housing market. Motivated by micro evidence, we embed optimizing homeowners with these preferences into a dynamic search and matching equilibrium model with rich heterogeneity and realistic constraints. We assess the model using large and granular administrative data tracking buyers and sellers in the UK housing market; the predictions match regional and time variation in price growth and transaction volumes. The model shows that behavioral frictions in a decentralized market can link nominal quantities with real outcomes; and reveals that the distribution of potential nominal gains in the housing market is a key policy-relevant statistic. |
| Keywords: | Reference dependence; behavioral frictions; housing |
| JEL: | D12 D91 G51 R21 R31 |
| Date: | 2024–01–12 |
| URL: | http://d.repec.org/n?u=RePEc:boe:boeewp:1054&r=upt |
| By: | Francesca Barigozzi (UNIBO - Alma Mater Studiorum Università di Bologna = University of Bologna); Helmuth Cremer (TSE-R - Toulouse School of Economics - UT Capitole - Université Toulouse Capitole - UT - Université de Toulouse - EHESS - École des hautes études en sciences sociales - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement); Jean-Marie Lozachmeur (TSE-R - Toulouse School of Economics - UT Capitole - Université Toulouse Capitole - UT - Université de Toulouse - EHESS - École des hautes études en sciences sociales - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, CNRS - Centre National de la Recherche Scientifique) |
| Abstract: | We study the design of pension benets for male and female workers. Women live longer than men but have a lower wage. Individuals can be single or live in couples who pool their incomes. Social welfare is utilitarian but an increasing concave transformation of individuals lifetime utilities introduces the concern for redistribution between individuals with di¤erent life-spans. We derive the optimal direction of redistribution and show how it is a¤ected by a gender neutrality rule. With singles only, a simple utilitarian solution implies re- distribution from males to females. When the transformation is su¢ ciently concave redistribution may or may not be reversed. With couples only, the ranking of gender retirement ages is always reversed when the transformation is su¢ ciently concave. Under gender neutrality pension schemes must be self-selecting. With singles only this implies distortions of retirement decision and restricts redistribution across genders. With couples, a rst best that implies a lower retirement age for females can be implemented by a gender-neutral system. Otherwise, gender neutrality implies equal retirement ages and restricts the possibility to compensate the shorter-lived individuals. Calibrated simulations show that when singles and couples coexist, gender neutrality substantially limits redistribution in favor of single women and fully prevents redistribution in favor of male spouses. |
| Keywords: | Gender wage gap, Gender gap in longevity, Retirement systems |
| Date: | 2023–05 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-03629490&r=upt |
| By: | Alexander Coutts (York University); Boon Han Koh (University of Exeter); Zahra Murad (University of Portsmouth) |
| Abstract: | Feedback is a vital tool used by organizations and educators to improve performance, spark learning, and foster individual growth. Yet, anecdotal evidence suggests that many individuals are hesitant to provide others with feedback. Moreover, gender biases may influence its provision, with consequences for the representation of women in leadership and com- petitive professions. We study feedback provision under different conditions that vary the nature of performance signals, how instrumental they are for decision making, and gender of the recipient. Our results reveal that a substantial degree of feedback is withheld by advisors. Moreover, advisors are more likely to shield women from negative feedback in conditions characterized both by a lack of complete information about performance, and feedback that is not immediately instrumental for their decision-making. This effect is driven by male advisors. Our findings showcase how gender differences can arise in feedback provision, and highlight when these differences may be more likely to appear. |
| Keywords: | Feedback Provision; Gender; Ego/Belief Utility; Competitiveness; Discrimination |
| JEL: | C90 D83 D91 J16 M54 |
| Date: | 2024–01–30 |
| URL: | http://d.repec.org/n?u=RePEc:pbs:ecofin:2024-02&r=upt |