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on Utility Models and Prospect Theory |
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Issue of 2024‒05‒13
sixteen papers chosen by |
| By: | Adam Brandenburger; Paolo Ghirardato; Daniele Pennesi; Lorenzo Stanca |
| Abstract: | In the world of subjective probability, there is no a priori reason why probabilities — interpreted as a willingness-to-bet—should necessarily lie in the interval [0, 1]. We weaken the Monotonicity axiom in classical subjective expected utility (Anscombe and Aumann, 1963) to obtain a representation of preferences in terms of an affine utility function and a signed (subjective) probability measure on states. We decompose this probability measure into a non-negative probability measure (“probability†) and an additive set function on states which sums to zero (“valence†). States with positive (resp. negative) valence are attractive (resp. aversive) for the decision maker. We show how our decision theory can resolve several paradoxes in decision theory, including “hedging aversion†(Morewedge et al., 2018), the conjunction effect (Tversky and Kahneman, 1982, 1983), the co-existence of insurance and betting (Friedman and Savage, 1948), and the choice of dominated strategies in strategyproof mechanisms (Hassidim et al., 2016). We extend our theory to allow for a non-additive willingness-to-bet, which also relaxes our earlier constraints on how valence can behave. |
| Keywords: | Signed probabilities, non-monotonicity, indifference substitution, valence, attractive and aversive states |
| Date: | 2024 |
| URL: | http://d.repec.org/n?u=RePEc:cca:wpaper:717&r=upt |
| By: | Christopher P. Chambers; Christopher Turansick |
| Abstract: | We study identification and linear independence in random utility models. We characterize the dimension of the random utility model as the cyclomatic complexity of a specific graphical representation of stochastic choice data. We show that, as the number of alternatives grows, any linearly independent set of preferences is a vanishingly small subset of the set of all preferences. We introduce a new condition on sets of preferences which is sufficient for linear independence. We demonstrate by example that the condition is not necessary, but is strictly weaker than other existing sufficient conditions. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.13773&r=upt |
| By: | Sendhil Mullainathan; Ashesh Rambachan |
| Abstract: | Machine learning algorithms can find predictive signals that researchers fail to notice; yet they are notoriously hard-to-interpret. How can we extract theoretical insights from these black boxes? History provides a clue. Facing a similar problem -- how to extract theoretical insights from their intuitions -- researchers often turned to ``anomalies:'' constructed examples that highlight flaws in an existing theory and spur the development of new ones. Canonical examples include the Allais paradox and the Kahneman-Tversky choice experiments for expected utility theory. We suggest anomalies can extract theoretical insights from black box predictive algorithms. We develop procedures to automatically generate anomalies for an existing theory when given a predictive algorithm. We cast anomaly generation as an adversarial game between a theory and a falsifier, the solutions to which are anomalies: instances where the black box algorithm predicts - were we to collect data - we would likely observe violations of the theory. As an illustration, we generate anomalies for expected utility theory using a large, publicly available dataset on real lottery choices. Based on an estimated neural network that predicts lottery choices, our procedures recover known anomalies and discover new ones for expected utility theory. In incentivized experiments, subjects violate expected utility theory on these algorithmically generated anomalies; moreover, the violation rates are similar to observed rates for the Allais paradox and Common ratio effect. |
| Date: | 2024–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2404.10111&r=upt |
| By: | Sebastian Schweighofer-Kodritsch |
| Abstract: | This chapter presents a microeconomic, behavioral perspective on bounded rationality and beliefs. It begins with an account of how research on belief biases, in particular via probabilistic belief elicitation, has become mainstream in economics only relatively recently and late, even in behavioral economics (aka “psychology and economics”). The chapter then offers a review of the decision-theoretic foundations of modeling and eliciting (subjective) beliefs as probabilities, as well as selected—both classic and recent—evidence on humans’ bounded rationality from related research in psychology and economics. In doing so, it connects the historical debates within decision theory, on the one hand, and within psychology, on the other, concerning the normative status of expected utility and Bayesianism, as well as its methodological implications. A conclusion draws lessons for the practice of belief elicitation and future research. |
| Date: | 2024–04–18 |
| URL: | http://d.repec.org/n?u=RePEc:bdp:dpaper:0037&r=upt |
| By: | Yunmin Chen (National Central University, Taiwan); Jang-Ting Guo (Department of Economics, University of California Riverside) |
| Abstract: | In the context of a dynamic (three-period) general equilibrium model, this paper examines the optimal tax rates on capital savings and labor income under quasi-hyperbolic discounting and idiosyncratic productivity shocks. In the absence of skill-type uncertainty, we analytically show that the marginal capital tax wedges on agents' first-period savings are negative for correcting inherent preference internalities, and that these tax rates will be higher when productivity disturbances are incorporated. In the stochastic two-type setting with exogenously-given factor input prices, our calibrated numerical experiments find that the marginal capital wedges for both types on their period-1 savings are positive, indicating the government's motive to relax individuals' incentive-compatibility constraints. We also quantitatively find that the optimal tax rates for both types on their first- and second-period capital savings, as well as the economy's social welfare, are ceteris paribus decreasing in the degree of quasi-hyperbolic discounting because of a stronger need to rectify negative utility internalities. |
| Keywords: | Optimal Dynamic Income Taxation; Quasi-Hyperbolic Discounting; Idiosyncratic Productivity Shocks. |
| JEL: | D91 H21 H24 |
| Date: | 2024–04 |
| URL: | http://d.repec.org/n?u=RePEc:ucr:wpaper:202403&r=upt |
| By: | Tayfun Sönmez (Boston College); M. Utku Ünver (Boston College) |
| Abstract: | We survey the literature on matching theory under non-transferable utility using a classification based on property rights (i) with private ownership, (ii) with common and mixed ownership, and (iii) under priority-based entitlements. |
| Keywords: | Matching Theory, Housing Markets, Two-sided Matching, Roommates Problem, Kidney Exchange, House Allocation, Student Placement, Reserve Systems |
| JEL: | C78 D47 |
| Date: | 2024–04–15 |
| URL: | http://d.repec.org/n?u=RePEc:boc:bocoec:1068&r=upt |
| By: | Mika Akesaka (Research Institute of Economics and Business Administration, Kobe University, JAPAN); Ryo Mikami (Faculty of Economics and Law, Shinshu University, JAPAN); Yoshiyasu Ono (Institute of Social and Economic Research, Osaka University, JAPAN) |
| Abstract: | This study theoretically considers household behavior with wealth preference and empirically investigates the validity of insatiable wealth preference using a nationally representative survey. With wealth preference, the marginal rate of substitution of asset holdings for consumption depends on the nominal interest rates of assets at each point in time. We focus on this property and find that the marginal utility of holding financial assets remains strictly positive as asset holdings increase and has a strictly positive lower bound, implying the insatiability of wealth preference. This property plays a crucial role in creating secular demand stagnation and expanding asset price bubbles. |
| Keywords: | Wealth preference; Survey data; Secular stagnation; Bubbles |
| JEL: | D12 E21 E43 E71 |
| Date: | 2024–04 |
| URL: | http://d.repec.org/n?u=RePEc:kob:dpaper:dp2024-16&r=upt |
| By: | Rene Schwaiger; Markus Strucks; Stefan Zeisberger |
| Abstract: | Narrow bracketing in combination with loss aversion has been shown to reduce individual risk-taking. This is known as myopic loss aversion (MLA) and has been corroborated by many studies. Recent evidence has contested this notion indicating that MLA’s applicability is confined to highly artificial settings. Given the impact of these findings, we reevaluated the evidence on MLA involving a total of 2, 245 university students, thereby achieving substantially higher statistical power than in almost all previous studies. To clarify inconsistencies in the literature, specifically under more realistic investment environments, we systematically modified the seminal study design by Gneezy and Potters (1997) to include five key adjustments. These involved realistic, down-scaled returns, return compounding, and extended investment horizons. Contrary to some prior studies that have raised doubts about the robustness of MLA, our results—which are highly robust to analytical heterogeneity—consistently document the presence of MLA across all experimental conditions. Our findings substantiate the widespread applicability of MLA and underscore the benefits of disclosing aggregated returns in practical financial decision-making contexts. |
| Keywords: | myopic loss aversion, narrow framing, risk-taking, meta science, replication |
| JEL: | D14 D81 G02 G11 |
| Date: | 2024–05 |
| URL: | http://d.repec.org/n?u=RePEc:inn:wpaper:2024-05&r=upt |
| By: | d'Artis Kancs |
| Abstract: | Motivated by the recently experienced systemic shocks (the COVID-19 pandemic and the full-fledged Russia’s war of aggression against Ukraine) – that have created new forms of uncertainties to our supplies – this paper explores the supply chain robustness under risk aversion and ambiguity aversion. We aim to understand the potential consequences of deeply uncertain systemic events on the supply chain resilience and how does the information precision affect individual agents’ choices and the chain-level preparedness to aggregate shocks. Augmenting a parsimonious supply chain model with uncertainty, we analyse the relationship between the upstream sourcing decisions and the supply chain survival probability. Both risk-averse and ambiguity-averse individually-optimising agents’ upstream sourcing paths are efficient but can become vulnerable to aggregate shocks. In contrast, a chain-level coordination of downstream firm sourcing decisions can qualitatively improve the robustness of the entire supply chain compared to the individual decision-making baseline. Such a robust decision making ensures that in the presence of an aggregate shock – independently of its realisation – part of upstream suppliers will survive and the final goods’ supply will be ensured even under the most demanding circumstances. Our results also indicate that an input source diversification extracts a cost in foregone efficiency. |
| Keywords: | Resilience, Robustness, Global Supply Chain, uncertainty, risk, ambiguity. |
| JEL: | E7 F02 F12 F13 L15 |
| Date: | 2024–04–03 |
| URL: | http://d.repec.org/n?u=RePEc:eei:rpaper:eeri_rp_2024_03&r=upt |
| By: | Adam Feher (Institute for Labour Law and Industrial Relations in the European Union (IAAEU), Trier University) |
| Abstract: | The degree of access granted to employees to a firm’s critical asset is a pivotal organizational decision. This access can boost the employees’ productivity within the firm but also enables them to become competitors after leaving, leading to a holdup problem. Economic theory suggests that non-competition agreements (noncompetes) can mitigate this issue. This paper examines the optimal compensation package for an employee, considering access, wage, and noncompete agreements. I demonstrate that firms compensate lower ability agents primarily through access, coupled with the minimum wage and strictest noncompete agreements since access not only increases the employee’s utility but also the firm’s production. For higher ability agents, the maximum degree of access is provided, while the wage and stringency of the noncompete depends on the damage the employee causes with competing. For low damages, the firm offers a lax noncompete with lower wages. Conversely, high potential damage necessitates higher wages and a stricter noncompete. The study’s findings are consistent with observed patterns in CEO contracts. |
| Keywords: | Noncompete agreements, wage differential, Optimal contract |
| JEL: | J31 J33 J42 |
| Date: | 2024–04 |
| URL: | http://d.repec.org/n?u=RePEc:iaa:dpaper:202404&r=upt |
| By: | Zhi Cao (Chinese University of Hong Kong); Arthur Lewbel (Boston College); Wenchao Li (Tongji University); Junjian Yi (Peking University) |
| Abstract: | We propose a new method for identifying bargaining power in collective house- hold models, based on information asymmetry. Our model allows household members to exploit an information advantage for bargaining. We formulate the household’s decision process under partial information disclosure using a Bayesian persuasion framework. We use this structure to point identify utility and bargaining power, which would not be identified under symmetric information. We illustrate these results by showing that our model can ex- plain known empirical outcomes regarding child educational investment and development in Chinese households where one parent is a migrant. |
| Keywords: | Collective model; Information asymmetry; Bargaining power; Bayesian persuasion; Left-behind children |
| JEL: | D11 D13 D82 D13 D82 J13 |
| Date: | 2024–04–26 |
| URL: | http://d.repec.org/n?u=RePEc:boc:bocoec:1070&r=upt |
| By: | Athias, Laure |
| Abstract: | The theory of social choice stresses that the general interest determined through the aggregation of individual preferences implies interpersonal utility comparisons and hence necessarily a notion of common good beyond individual preferences. The pursuit of the common good falls to all services of the state and drives their individual decisions. Economic model of identity in the workplace predicts that outsider public sector workers may internalize the common good value to minimize cognitive dissonance. To test this hypothesis, I study the dynamics of preferences for workers in public versus private sector jobs. For identification, I use panel data and exploit within-individual variations, alleviating endogeneity concern related to selection into occupation. Further addressing the dynamic omitted variable concern, I find that switching into the public sector increases by one third the likelihood of exhibiting the common good value while having a negative effect on public trust and left-wing ideology. By contrast, switching into the private sector crowds out common good value. Examining causal mechanisms, I show that the public sector effect is most pronounced for workers with higher dissonance costs. Furthermore, I find that workers adopting the common good value in the workplace adopt a general behavior consistent with active participation in the public realm, pointing to value internalization. Overall, this paper provides empirical evidence of a rich and rapid, dynamic interaction between individual preferences and economic institutions. |
| Keywords: | Value dynamics; Identity in the workplace; Cognitive dissonance; Common good; State; Public versus private sector; Crowding out effect; Workplace socialization; Institutional narrative. |
| JEL: | A13 D02 D63 D73 D83 H11 L33 N43 Z13 Z18 |
| Date: | 2024–03–30 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:120588&r=upt |
| By: | Adam, Martin; Roethke, Konstantin; Benlian, Alexander |
| Abstract: | To augment traditional monetization strategies, digital platform providers increasingly draw on gamblification (i.e., the use of gambling design elements). By means of gambling design elements (e.g., lottery tickets, scratch cards, loot boxes), platform providers do not only entertain users but also incentivize them to purchase digital products. Yet, despite the increasing prevalence of gamblified digital platforms, little is known about how gamblification influences user purchase behaviors. Drawing on prospect theory, we investigate gamblification in the form of loot box menu designs and the associated effects of uncertainty, loss experience and behavioral control on user purchase behavior. Specifically, we conducted a contest-based online experiment with 159 participants, finding that platform providers can profit from offering loot boxes with certain (vs. uncertain) rewards in loot box menus. Furthermore, this effect intensifies when participants previously experienced a loss and decreases when they perceive to have more control over the result. Thus, our findings provide theoretical and practical insights for a better understanding of gamblification in general and of loot box menu designs for enhancing digital business models in particular. |
| Date: | 2024–03–26 |
| URL: | http://d.repec.org/n?u=RePEc:dar:wpaper:144177&r=upt |
| By: | Zhaolin Li; Artem Prokhorov |
| Abstract: | We revisit the fundamental issue of tail behavior of accumulated random realizations when individual realizations are independent, and we develop new sharper bounds on the tail probability and expected linear loss. The underlying distribution is semi-parametric in the sense that it remains unrestricted other than the assumed mean and variance. Our sharp bounds complement well-established results in the literature, including those based on aggregation, which often fail to take full account of independence and use less elegant proofs. New insights include a proof that in the non-identical case, the distributions attaining the bounds have the equal range property, and that the impact of each random variable on the expected value of the sum can be isolated using an extension of the Korkine identity. We show that the new bounds not only complement the extant results but also open up abundant practical applications, including improved pricing of product bundles, more precise option pricing, more efficient insurance design, and better inventory management. |
| Date: | 2024–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2404.02400&r=upt |
| By: | Mathias Krogh (Aarhus University); Giovanni Pellegrino (University of Padova and Aarhus University) |
| Abstract: | We extend a state-of-the-art DSGE model to include short- and long-term uncertainty shocks that differ in terms of persistence. Considering the two shocks is essential for capturing the imperfect empirical relationship between short- and long-term financial uncertainty as proxied by the VIX. Leveraging the model’s implications about the VIX term structure, we suggest a theory-informed, nonrecursive identification strategy to separately identify the macroeconomic effects of the two shocks in a structural VAR. In line with the DSGE model, long-term uncertainty shocks have stronger and more persistent real effects than short-term shocks. Moreover, they explain a substantial fraction of the forecast error variance in unemployment and the policy rate at horizons greater than two years. In a supplementary analysis of uncertainty news shocks, we show that news about higher uncertainty in the future is recessionary. |
| Keywords: | uncertainty shocks, medium-scale DSGE model, structural VAR, nonrecursive identification, VIX term structure. |
| URL: | http://d.repec.org/n?u=RePEc:pad:wpaper:0310&r=upt |
| By: | Tayfun Sönmez (Boston College); M. Utku Ünver (Boston College) |
| Abstract: | We survey the literature on applications of matching theory under non- transferable utility. We cover the following six applications in detail: living-donor kid- ney exchange, living-donor liver exchange, cadet-branch matching in the US Army, affirmative action in India, matching market for entry-level physicians in the US, and course allocation at universities. We also survey other notable applications. |
| Keywords: | Matching Theory, Market Design, Kidney Exchange, Liver Exchange, Cadet- Branch Matching, Affirmative Action in India, Matching for Residency Programs, NRMP, Unraveling, Course Allocation, College Admissions, School Choice, Pandemic Resource Al- location, Reserve Systems, Matching under Distributional Constraints, Matching with Reassignment, Balancedness in Matching, Refugee Resettlement |
| JEL: | C78 D47 |
| Date: | 2024–04–15 |
| URL: | http://d.repec.org/n?u=RePEc:boc:bocoec:1069&r=upt |