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on Utility Models and Prospect Theory |
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Issue of 2024‒06‒24
fourteen papers chosen by |
| By: | Martin Herdegen; Nazem Khan; Cosimo Munari |
| Abstract: | Risk and utility functionals are fundamental building blocks in economics and finance. In this paper we investigate under which conditions a risk or utility functional is sensitive to the accumulation of losses in the sense that any sufficiently large multiple of a position that exposes an agent to future losses has positive risk or negative utility. We call this property sensitivity to large losses and provide necessary and sufficient conditions thereof that are easy to check for a very large class of risk and utility functionals. In particular, our results do not rely on convexity and can therefore also be applied to most examples discussed in the recent literature, including (non-convex) star-shaped risk measures or S-shaped utility functions encountered in prospect theory. As expected, Value at Risk generally fails to be sensitive to large losses. More surprisingly, this is also true of Expected Shortfall. By contrast, expected utility functionals as well as (optimized) certainty equivalents are proved to be sensitive to large losses for many standard choices of concave and nonconcave utility functions, including $S$-shaped utility functions. We also show that Value at Risk and Expected Shortfall become sensitive to large losses if they are either properly adjusted or if the property is suitably localized. |
| Date: | 2024–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2405.12154&r= |
| By: | Keyu Wu; Ernst Fehr; Sean Hofland; Martin Schonger |
| Abstract: | Ambiguous prospects are ubiquitous in social and economic life, but the psychological foundations of behavior under ambiguity are still not well understood. One of the most robust empirical regularities is the strong correlation between attitudes towards ambiguity and compound risk which suggests that compound risk aversion may provide a psychological foundation for ambiguity aversion. However, compound risk aversion and ambiguity aversion may also be independent psychological phenomena, but what would then explain their strong correlation? We tackle these questions by training a treatment group’s ability to reduce compound to simple risks, and analyzing how this affects their compound risk and ambiguity attitudes in comparison to a control group who is taught something unrelated to reducing compound risk. We find that aversion to compound risk disappears almost entirely in the treatment group, while the aversion towards both artificial and natural sources of ambiguity remain high and are basically unaffected by the teaching of how to reduce compound lotteries. Moreover, similar to previous studies, we observe a strong correlation between compound risk aversion and ambiguity aversion, but this correlation only exists in the control group while in the treatment group it is rather low and insignificant. These findings suggest that ambiguity attitudes are not a psychological relative, and derived from, attitudes towards compound risk, i.e., compound risk aversion and ambiguity aversion do not share the same psychological foundations. While compound risk aversion is primarily driven by a form of bounded rationality – the inability to reduce compound lotteries – ambiguity aversion is unrelated to this inability, suggesting that ambiguity aversion may be a genuine preference in its own right. |
| Date: | 2024–05 |
| URL: | https://d.repec.org/n?u=RePEc:zur:econwp:444&r= |
| By: | Zongxia Liang; Qi Ye |
| Abstract: | This paper delves into financial markets that incorporate a novel form of heterogeneity among investors, specifically in terms of their beliefs regarding the reliability of signals in the business cycle economy model, which may be biased. Unlike most papers in this field, we not only analyze the equilibrium but also examine welfare using objective measures while investors aim to maximize their utility based on subjective measures. Furthermore, we introduce passive investors and use their utility as a benchmark, thereby revealing the phenomenon of double loss sometimes. In the analysis, we examine two effects: the distortion effect on total welfare and the advantage effect of information and highlight their key factors of influence, with a particular emphasis on the proportion of investors. We also demonstrate that manipulating investors' estimation towards the economy can be a way to improve utility and identify an inner connection between welfare and survival. |
| Date: | 2024–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2405.08822&r= |
| By: | Tolulope Fadina; Thorsten Schmidt |
| Abstract: | Fairness in decision-making processes is often quantified using probabilistic metrics. However, these metrics may not fully capture the real-world consequences of unfairness. In this article, we adopt a utility-based approach to more accurately measure the real-world impacts of decision-making process. In particular, we show that if the concept of $\varepsilon$-fairness is employed, it can possibly lead to outcomes that are maximally unfair in the real-world context. Additionally, we address the common issue of unavailable data on false negatives by proposing a reduced setting that still captures essential fairness considerations. We illustrate our findings with two real-world examples: college admissions and credit risk assessment. Our analysis reveals that while traditional probability-based evaluations might suggest fairness, a utility-based approach uncovers the necessary actions to truly achieve equality. For instance, in the college admission case, we find that enhancing completion rates is crucial for ensuring fairness. Summarizing, this paper highlights the importance of considering the real-world context when evaluating fairness. |
| Date: | 2024–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2405.09360&r= |
| By: | Takeshi Kato; Mohammad Rezoanul Hoque |
| Abstract: | Reducing wealth inequality and increasing utility are critical issues. This study reveals the effects of redistribution and consumption morals on wealth inequality and utility. To this end, we present a novel approach that couples the dynamic model of capital, consumption, and utility in macroeconomics with the interaction model of joint business and redistribution in econophysics. With this approach, we calculate the capital (wealth), the utility based on consumption, and the Gini index of these inequality using redistribution and consumption thresholds as moral parameters. The results show that: under-redistribution and waste exacerbate inequality; conversely, over-redistribution and stinginess reduce utility; and a balanced moderate moral leads to achieve both reduced inequality and increased utility. These findings provide renewed economic and numerical support for the moral importance known from philosophy, anthropology, and religion. The revival of redistribution and consumption morals should promote the transformation to a human mutual-aid economy, as indicated by philosopher and anthropologist, instead of the capitalist economy that has produced the current inequality. The practical challenge is to implement bottom-up social business, on a foothold of worker coops and platform cooperatives as a community against the state and the market, with moral consensus and its operation. |
| Date: | 2024–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2405.13341&r= |
| By: | Lee, King Fuei |
| Abstract: | The momentum effect is postulated to be a consequence of the disposition effect, which in turn, is a result of the interplay between the typically dominant diminishing sensitivity feature of prospect theory and the loss aversion feature. However, studies have shown that older individuals can exhibit a reverse disposition effect due to their heightened loss aversion compared to younger individuals. This paper hypothesises that as the population ages, the disposition effect of the average investor starts to diminish, thereby inducing a corresponding weakening of the momentum effect. We find empirical evidence showing that the long-horizon momentum profits are negatively related to changes in the proportion of the older population. |
| Keywords: | Momentum, demographics, prospect theory, loss aversion, diminishing sensitivity, aging population, disposition effect |
| JEL: | G12 J14 |
| Date: | 2023 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:120931&r= |
| By: | Kirchler, Benjamin; Kirchler, Erich |
| Abstract: | We study the impact of social reference points (SRPs) on decisions under uncertainty. Participants in an online experiment observed the earnings of a matched peer, which was either a high or low amount of money (SRP condition). Subsequently, they made decisions under different degrees of uncertainty (uncertainty condition) with known and uncertain probabilities of outcomes. Risky and ambiguous decisions are operationalized by a modified version of the Bomb Risk Elicitation Task (BRET).We find that SRPs shape decisions under uncertainty: observing a high SRP decreases risk aversion significantly, especially when peer earnings are salient. Moreover, our results suggest that the degree of uncertainty affects the impact of SRPs. SRPs loom larger in decisions under ambiguity compared to risky decisions. Further details of the results suggest that behavior is consistent with social comparison theory. Participants observing a low SRP decrease risks taking to avoid social loss by collecting a bomb and receiving zero earnings, while participants observing a high SRP increase risk taking to decrease the gap to the peer and reduce social losses. |
| Keywords: | Choice under uncertainty, risk taking, ambiguity, social comparison, inequity aversion |
| JEL: | D03 |
| Date: | 2024–03–11 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:121054&r= |
| By: | Pierpaolo Battigalli; Giovanni Di Bartolomeo; Stefano Papa |
| Abstract: | This research investigates the motivations in sharing decisions in a dictator game, trying to distinguish the role of guilt aversion from other social preferences, such as altruism and inequity aversion. Using an experimental design that incorporates exogenous variations in beliefs and endowments, we manipulate probabilities to generate scenarios with varying expected sharing costs. This approach allows for an in-depth examination of how sharing behaviors correlate with second-order beliefs across different cost conditions. Focusing on the guilt and inequity aversion channels, the study also explores how gender in‡fluences behavior. |
| Keywords: | expectations; guilt aversion; inequity aversion; opportunity costs; gender differences. |
| JEL: | A13 C91 D01 D64 |
| Date: | 2024–05 |
| URL: | https://d.repec.org/n?u=RePEc:sap:wpaper:wp248&r= |
| By: | Ludovic A. Julien; Gagnie Pascal Yebarth |
| Abstract: | This paper explores the possibility that a taxation mechanism always implements a Pareto-optimal allocation in bilateral exchange when the market participants behave strategically and noncooperatively. To this end, we reconsider the taxation mechanism, namely the endowment taxation with transfers, implemented in the strategic bilateral exchange models by Gabszewicz and Grazzini (JPET, 1999). In this framework of strategic bilateral exchange, we consider a general class of smooth utility functions, and we determine the conditions under which the taxation mechanism is Pareto-optimal, i.e., whether there exists an equilibrium tax such that endowment taxation with transfers always implements a Pareto-optimal allocation. Furthermore, we explain why this taxation mechanism could implement a Pareto-optimal allocation. |
| Keywords: | Cournot-Nash equilibrium, Pareto-optimality, taxation |
| JEL: | C72 D41 H21 |
| Date: | 2024 |
| URL: | https://d.repec.org/n?u=RePEc:drm:wpaper:2024-19&r= |
| By: | Luis Guijarro; Maurizio Naldi; Vicent Pla; Jose-Ramon Vidal |
| Abstract: | In Beyond5G and 6G networks, a common theme is that sensing will play a more significant role than ever before. Over this trend, Integrated Sensing and Communications (ISAC) is focused on unifying the sensing functionalities and the communications ones and to pursue direct tradeoffs between them as well as mutual performance gains. We frame the resource tradeoff between the SAC functionalities within an economic setting. We model a service provision by one operator to the users, the utility of which is derived from both SAC functionalities. The tradeoff between the resources that the operator assigns to the SAC functionalities is analyzed from the point of view of the service prices, quantities and profits. We demonstrate that equilibrium quantities and prices exist. And we provide relevant recommendations for enforcing regulatory limits of both power and bandwidth. |
| Date: | 2024–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2405.09963&r= |
| By: | Hanappi, Hardy |
| Abstract: | Predictions and hopes are different things. Predictions are based on past empirical observations. They single out what seem to be essential variables and the relationships between them and assume that their importance will prevail in the future. Hopes add a component to a prediction, namely an evaluation, which refers back to the entity that produces the prediction. The path-breaking book of Neumann and Morgenstern started with a concise, axiomatic formalisation of utility theory, id est the microeconomic conceptualisation of hopes, and in the following chapters steps into the jungle of strategic decision-making, id est making predictions about sets of strategic outcomes, commonly known as game theory . This paper inverts this sequence: first predictions, then hopes. The reason is simple. The idea that hopes can be encapsulated in a rigid setup of a preference order of an individual human decision-maker is misleading. Hopes are dynamic, hopes are emerging; and not at all inborn properties of human individuals. Most of them grow out of a rich and informed communication sphere. And in this information sphere, which so far has not been reduced to a unified axiomatic formal model of the ‘information sphere of the human species’, the emergence of preliminary predictions made by social entities is the first step towards hopes. This is why preliminary predictions are described before the emerging hopes are taken into the picture. Both, predictions and hopes, remain in a preliminary and unprecise state – contrary to the aspirations of game theory. But note that this approach allows much better for a flexible response to changing theoretical needs than to rely on so-called ‘heroic’ assumptions. In reconnecting hopes and predictions an additional advantage is that a mixture of pessimism and optimism can be achieved, which is a necessary ingredient for the stimulation of progress. |
| Keywords: | Political Economy, Globalisation |
| JEL: | B50 F01 P00 |
| Date: | 2024–05–21 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:121008&r= |
| By: | Dazhuo Wei |
| Abstract: | In this paper, I introduce a random attention span model (RAS) which uses stopping time to identify decision-makers' behavior under limited attention. Unlike many limited attention models, the RAS identifies preferences using time variation without any need for menu variation. In addition, the RAS allows the consideration set to be correlated with the preference. I also use the revealed preference theory that provides testable implications for observable choice probabilities. Then, I test the model and estimate the preference distribution using data from M-Turk experiments on choice behaviors that involve lotteries; there is general alignment with the distribution results from logit attention model. |
| Date: | 2024–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2405.11578&r= |
| By: | Adam S. Tuzolele Mbuku (Université catholique du Congo - Université catholique du Congo) |
| Abstract: | Historically, Homo Economicus has been conceptualized as a perfectly rational individual who always seeks to maximize his utility. However, this assumption has been challenged by recent discoveries in neuroeconomics, which suggest that emotions and neural processes play a key role in economic decision-making. We have examined a variety of research works in the field of neuroeconomics, including those that explore the interaction between emotion and deliberation, the role of emotions in economic decisions, and how neural structures and mechanisms influence economic choices. These works have highlighted the importance of emotions in economic decision-making and have challenged the traditional assumption of Homo Economicus. Furthermore, we have explored how discoveries in neuroeconomics can help improve existing economic models by integrating knowledge about brain functioning. We have also discussed the potential implications of neuroeconomics for economic policy, particularly in the context of the Democratic Republic of Congo. |
| Abstract: | Historiquement, l'Homo Economicus a été conceptualisé comme un individu parfaitement rationnel qui cherche toujours à maximiser son utilité. Cependant, cette hypothèse a été remise en question par les découvertes récentes en neuroéconomie, qui suggèrent que les émotions et les processus neuronaux jouent un rôle clé dans la prise de décision économique. Nous avons examiné une variété de travaux de recherche dans le domaine de la neuroéconomie, y compris ceux qui explorent l'interaction entre émotion et délibération, le rôle des émotions dans les décisions économiques, et comment les structures et les mécanismes neuronaux influencent les choix économiques. Ces travaux ont mis en évidence l'importance des émotions dans la prise de décision économique et ont remis en question l'hypothèse traditionnelle de l'homo economicus. En outre, nous avons exploré comment les découvertes en neuroéconomie peuvent aider à améliorer les modèles économiques existants en intégrant les connaissances sur le fonctionnement du cerveau. Nous avons également discuté des implications potentielles de la neuroéconomie pour la politique économique, en particulier dans le contexte de la République Démocratique du Congo. |
| Keywords: | Neuroeconomics, Cognitive biases, Behavioral economics, Economic model, Homo economicus, Neuroéconomie, Biais cognitifs, Économie comportementale, Modèle économique |
| Date: | 2024–04–30 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-04564775&r= |
| By: | Fabian Gouret (CY Cergy Paris Université, THEMA) |
| Abstract: | To enhance the realism of the spatial model of voting, several authors have added a valence parameter into a Downsian utility function. However, when doing so, they rarely discuss the value that the exponent on the distance between voters and candidates should take. For some values of the exponent and the valence- advantage of one candidate over another one, the single-crossing property cannot be assumed. This paper underscores the importance of this consideration by providing first a necessary and sufficient condition for this property not being satisfied. I then discuss the identification of the key parameters in two econometric frameworks to realize various hypothesis tests related to the single-crossing property. I use data from pre-election surveys of the American National Election Studies. I mainly focus on the 2008 Presidential election, and find some evidence against the single-crossing hypothesis. I also discuss the results with more recent US Presidential elections, but it is more difficult to find evidence against this hypothesis. |
| Keywords: | spatial models of voting, valence, single-crossing property, survey |
| JEL: | D72 C81 |
| Date: | 2024 |
| URL: | https://d.repec.org/n?u=RePEc:ema:worpap:2024-05&r= |