|
on Utility Models and Prospect Theory |
| By: | Pavlo R. Blavatskyy |
| Abstract: | This paper analyzes individual decision making under risk. It is assumed that an individual does not have a preference relation on the set of risky lotteries. Instead, an individual possesses a probability measure that captures the likelihood of one lottery being chosen over the other. Choice probabilities have a stochastic utility representation if they can be written as a non-decreasing function of the difference in expected utilities of the lotteries. Choice probabilities admit a stochastic utility representation if and only if they are complete, strongly transitive, continuous, independent of common consequences and interchangeable. Axioms of stochastic utility are consistent with systematic violations of betweenness and a common ratio effect but not with a common consequence effect. Special cases of stochastic utility include the Fechner model of random errors, Luce choice model and a tremble model of Harless and Camerer (1994). |
| Keywords: | Expected utility theory, stochastic utility, Fechner model, Luce choice model, tremble |
| JEL: | C91 D81 |
| Date: | 2007–01 |
| URL: | http://d.repec.org/n?u=RePEc:zur:iewwpx:311&r=upt |
| By: | S. D. Flåm.; L. Koutsougeras |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:man:sespap:0703&r=upt |
| By: | Pavlo Blavatskyy; Ganna Pogrebna |
| Abstract: | Economic research offers two traditional ways of analyzing decision making under risk. One option is to compare the goodness of fit of different decision theories using the same model of stochastic choice. An alternative way is to vary models of stochastic choice combining them with only one or two decision theories. This paper proposes to look at the bigger picture by comparing different combinations of decision theories and models of stochastic choice. We select a menu of seven popular decision theories and embed each theory in five models of stochastic choice including tremble, Fechner and random utility model. We find that the estimated parameters of decision theories differ significantly when theories are combined with different models. Depending on the selected model of stochastic choice we obtain different ranking of decision theories with regard to their goodness of fit to the data. The fit of all analyzed decision theories improves significantly when they are embedded in a Fechner model of heteroscedastic truncated errors (or random utility model in a dynamic decision problem). |
| Keywords: | Fechner model, random utility, tremble, expected utility theory, risk |
| JEL: | C93 D81 |
| Date: | 2007–04 |
| URL: | http://d.repec.org/n?u=RePEc:zur:iewwpx:319&r=upt |
| By: | Pavlo R. Blavatskyy; Wolfgang R. Köhler |
| Abstract: | A standard method to elicit the certainty equivalent of a risky lottery is the Becker-DeGroot-Marschak (BDM) procedure. In the BDM procedure an individual bids her minimum selling price for a lottery in a second-price auction against a randomly drawn number. Experimental results presented in this paper demonstrate that elicited prices are systematically affected by the interval from which the random number is drawn. Expected utility theory cannot explain these results. Non-expected utility theories can only explain the results if subjects consider compound lotteries generated by the BDM procedure. We present an alternative explanation where subjects sequentially compare the lottery to monetary amounts in order to determine their minimum selling price. |
| Keywords: | Certainty equivalent, experiment, stochastic, Becker-DeGroot-Marschak (BDM) method, elicitation procedure |
| JEL: | C91 D81 |
| Date: | 2007–05 |
| URL: | http://d.repec.org/n?u=RePEc:zur:iewwpx:323&r=upt |
| By: | TREICH Nicolas; |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:ler:wpaper:08.05.249&r=upt |
| By: | Adam Elbourne; Debby Lanser; Bert Smid; Martin Vromans |
| Abstract: | We use the dynamic stochastic general equilibrium (DSGE) model of Altig et al. (2005) to analyse the resilience of an economy in the face of external shocks. The term resilience refers to the ability of an economy to propser in the face of shocks. The Altig et al. model was chosen because it combined both demand and supply shocks and because various market rigidities/imperfections, which have the potential to affect resilience, are modelled. We consider the level of expected discounted utility to be the relevant measure of resilience. The effect of market rigidities, eg. wage and price stickiness, on the expected level of utility is minimal. The effect on utility is especially small when compared to the effect of market competition, because the latter has a direct effect on the level of output. This conclusion holds for the family of constant relative risk aversion over consumption utility functions. A similar conclusion was drawn by Lucas (1987) regarding the costs of business cycles. We refer to the literature that followed Lucas for ideas for how a DSGE model might be adjusted to give a more meaningful analysis of resilience. We conclude that the Altig et al. DSGE model does not produce a relationship between rigidities and the level of output and, hence, does not capture the effect of inflexibility on utility that one observes colloquially. |
| Keywords: | Resilience; Nominal Rigidities; Capital Adjustment Costs; DSGE Models |
| JEL: | E17 E27 E37 C32 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpb:discus:96&r=upt |
| By: | Horst Zank |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:man:sespap:0710&r=upt |
| By: | Itzhak Gilboa (Department of Economic, Tel-Aviv University); Andrew Postlewaite (Department of Economics, University of Pennsylvania); David Schmeidler (Department of Economics, Ohio State University) |
| Abstract: | Economic modeling assumes, for the most part, that agents are Bayesian, that is, that they entertain probabilistic beliefs, objective or subjective, regarding any event in question. We argue that the formation of such beliefs calls for a deeper examination and for explicit modeling. Models of belief formation may enhance our understanding of the probabilistic beliefs when these exist, and may also help up characterize situations in which entertaining such beliefs is neither realistic nor necessarily rational. |
| Keywords: | Decision making, Bayesian, Behavioral Economics |
| JEL: | B4 D8 |
| Date: | 2007–08–01 |
| URL: | http://d.repec.org/n?u=RePEc:pen:papers:08-002&r=upt |
| By: | Pavlo R. Blavatskyy |
| Abstract: | This paper presents a new incentive compatible method for measuring confidence in own knowledge. This method consists of two parts. First, an individual answers several general knowledge questions. Second, the individual chooses among three alternatives: 1) one question is selected at random and the individual receives a payoff if he or she has answered this question correctly; 2) the individual receives the same payoff with a probability equal to the percentage of correctly answered questions; 3) either the first or the second alternative is selected. The choice of the first (second) alternative reveals overconfidence (underconfidence). The individual is well calibrated if he or she chooses the third alternative. Experimental results show that subjects, on average, exhibit underconfidence about their own knowledge when the incentive compatible mechanism is used. Their confidence in own knowledge does not depend on their attitude towards risk/ambiguity. |
| Keywords: | Overconfidence, underconfidence, lottery, experiment, risk aversion |
| JEL: | C91 D81 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:zur:iewwpx:358&r=upt |
| By: | Michael H. Birnbaun; Ulrich Schmidt |
| Abstract: | Several models of choice under uncertainty imply systematic violations of transitivity of preference. Our experiments explored whether people show patterns of intransitivity predicted by these models. To distinguish “true” violations from those produced by “error,” a model was fit in which each choice can have a different error rate and each person can have a different pattern of true preferences that does not need to be transitive. Error rate for a choice is estimated from preference reversals between repeated presentations of the same choice. Our results showed that very few people repeated intransitive patterns. We can retain the hypothesis that transitivity best describes the data of the vast majority of participants. |
| Keywords: | decision making, errors, regret theory, transitivity |
| JEL: | C91 D81 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:kie:kieliw:1396&r=upt |
| By: | Wolfgang R. Köhler |
| Abstract: | A large experimental and empirical literature on asymmetric dominance and attraction effects shows that the probability that an alternative is chosen can increase if additional alternatives become available. Hence context matters and choices and, therefore, market shares can not be accurately described by standard choice models where individuals choose the alternative that yields the highest utility. This paper analyzes a simple procedural choice model. Individuals determine their choice by a sequence of binary comparisons. The model offers an intuitive explanation for violations of regularity such as the attraction and the asymmetric dominance effect and shows their relation to the similarity effect. The model analyzes a new rationale why context matters. The model is applied to explain primacy and recency effects and to derive implications with respect to product design. |
| Keywords: | Asymmetric dominance, attraction effect, similarity effect, binary choice, primacy effect, recency effect, regularity |
| JEL: | D11 M31 |
| Date: | 2007–07 |
| URL: | http://d.repec.org/n?u=RePEc:zur:iewwpx:330&r=upt |
| By: | Fabio Fornari (European Central Bank, DG Economics, Foreign Exchange and Balance of Payments Section, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.) |
| Abstract: | Volatilities implied from interest rate swaptions are used to assess the size and the sign of the compensation for volatility risk, for dollar, euro and pound rates at a daily frequency, between October 1998 and August 2006. The measurement of the volatility risk premium rests on a simple model according to which variance forecasts are generated under the objective probability measure. Results show that especially between September 2001 and mid-2003 dollar implieds were embodying a large - negative - compensation for volatility risk, a component which was smaller in absolute terms - but not relative to the level of the respective implied volatilities - for the other two currencies. While the negative compensation for volatility risk is in line with previous studies focusing on other asset classes, we also document that it exhibits a term structure, more evident for dollar and euro rates than for pound rates. The volatility risk premium is strongly changing through time but much less than implied volatilities. Estimates of risk aversion based on the physical skewness and kurtosis of interest rate changes suggest that (minus) the volatility risk premium can almost directly be read as risk aversion, as its proportionality with such risk aversion measure is about 0.8. Also, compensation for volatility risk is positively related to expected volatility, although the relation is not completely linear. Daily compensation for volatility risk is influenced, as expected, by the level of the short term rate and its volatility as well as by a small but robust number of macroeconomic surprises. The latter induce more sizeable changes on compensation for volatility risk of dollar rates than of euro or pound rates. JEL Classification: G120, G130, G140. |
| Keywords: | Volatility risk premium, risk aversion, economic surprises. |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20080859&r=upt |
| By: | Gaudecker, H.M. von; Soest, A.H.O. van; Wengstrom, E. (Tilburg University, Center for Economic Research) |
| Abstract: | We combine data from a risk preference elicitation experiment conducted on a representative sample via the Internet with laboratory data on student subjects for the same experiment in order to investigate effects of implementation mode and of subject pool selection. We find that the frequency of errors in the lab experiment is drastically below that of the representative sample in the Internet experiment, and average risk aversion is lower as well. Considering the student-like subsample of the Internet subjects and comparing a traditional lab design with an Internet-like design in the lab gives us two ways to decompose these differences into differences due to subject pool selection and differences due to implementation mode. Both lead to the conclusion that the differerences are due to selection and not to implementation mode. An analysis of the various steps leading to participation or non-participation in the Internet survey leads to the conclusion that these processes are selective in selecting subjects who make fewer errors, but do not lead to biased conclusions on risk preferences. These findings point at the usefulness of the Internet survey as an alternative to a student pool in the laboratory if the ambition is to use the experiments to draw inference on a broad population. |
| Keywords: | Risk aversion;Internet surveys;Laboratory experiments |
| JEL: | C90 D81 |
| Date: | 2008 |
| URL: | http://d.repec.org/n?u=RePEc:dgr:kubcen:200811&r=upt |
| By: | Andreea Halunga; Chris D. Orme |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:man:sespap:0721&r=upt |
| By: | ALARY David; BIEN F. |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:ler:wpaper:08.06.250&r=upt |