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on Utility Models and Prospect Theory |
| By: | David B. Brown; Enrico G. De Giorgi; Melvyn Sim |
| Abstract: | In this paper, we axiomatize a target-based model of choice that allows decision makers to be both risk averse and risk seeking, depending on the payoff's position relative to a prespecified target. The approach can be viewed as a hybrid model, capturing in spirit two celebrated ideas: first, the satisficing concept of Simon (1955); second, the switch between risk aversion and risk seeking popularized by the prospect theory of Kahneman and Tversky (1979). Our axioms are simple and intuitive; in order to be implemented in practice, our approach requires only the specification of an aspiration level. We show that this approach is dual to a known approach using risk measures, thereby allowing us to connect to existing theory. Though our approach is intended to be normative, we also show that it resolves the classical paradoxes of Allais (1953) and Ellsberg (1961), neither of which can be explained by expected utility theory. |
| Keywords: | satisficing; aspiration levels; targets; prospect theory; reflection effect; risk measures; coherent risk measures; convex risk measures; portfolio optimization |
| JEL: | D81 G11 |
| Date: | 2009–05 |
| URL: | http://d.repec.org/n?u=RePEc:usg:dp2009:2009-09&r=upt |
| By: | Eike B. Kroll (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg); Bodo Vogt (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg) |
| Abstract: | The St. Petersburg is one of the oldest violations of expected utility theory. Thus far, explanations of the paradox aim at small probabili- ties being perceived as zero and the boundedness of utility. This paper provides experimental results showing that neither risk attitudes nor perception of small probabilities explain the paradox. We nd that even in situations where subjects are risk-seeking, the St. Petersburg Paradox exists. This indicates that the paradox lies at the very core of human decision-making processes and cannot be explained by the parameters discussed in previous research so far. |
| Date: | 2009–01 |
| URL: | http://d.repec.org/n?u=RePEc:mag:wpaper:09004&r=upt |
| By: | Sujoy Mukerji |
| Abstract: | Are foundations of models of ambiguity-sensitive preferences too flawed to be usefully applied to economic models? Al-Najjar and Weinstein (2009) say such is indeed the case. In this paper, first, we point out that many of the key arguments by Al-Najjar and Weinstein do not apply to quite a few of the ambiguity preference models of more recent vintage, and therefore to that extent do not undermine the foundational aspects or applicability of ambiguity models in general. Second, we argue the focus in that paper on Ellsberg examples is an overly narrow concern; the Ellsberg examples have their uses but they are not the best context to understand why reasonable real-world agents may find acting with ambiguity-sensitive preferences normatively or prescriptively appealing. Finally, normative considerations aside, we submit that Al-Najjar and Weinstein are unduly dismissive of the power of such preferences to provide illuminating positive analyses of economic phenomena. |
| Keywords: | Ambiguity, Uncertainty, Knightian uncertainty, Ambiguity aversion, Uncertainty aversion, Ellsberg paradox, Dynamic decision making, Dynamic Programming under ambiguity, Smooth ambiguity, Consequentialism, Sunk cost fallacy, Multiple priors, Rationality |
| JEL: | D80 D81 |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:oxf:wpaper:433&r=upt |
| By: | Edi Karni |
| Abstract: | This paper presents a complete, choice-based, axiomatic Bayesian decision theory. It introduces a new choice set consisting of information-contingent plans for choosing actions and bets and subjective expected utility model with effect-dependent utility functions and action-dependent subjective probabilities which, in conjunction with the updating of the probabilities using Bayes' rule, gives rise to a unique prior and a set of action-dependent posterior probabilities representing the decision maker's prior and posterior beliefs. |
| Date: | 2009–05 |
| URL: | http://d.repec.org/n?u=RePEc:jhu:papers:550&r=upt |
| By: | Juan-Angel Jimenez-Martin (Dpto. de Fundamentos de Análisis Económico II, Universidad Complutense); Alfonso Novales Cinca (Dpto. de Fundamentos de Análisis Económico II, Universidad Complutense) |
| Abstract: | This paper introduces state-uncertainty preferences into the Lucas (1982) economy, showing that this type of preferences helps to explain the exchange rate risk premium. Under these preferences we can distinguish between two factors driving the exchange rate risk premium: “macroeconomic risk” and “the risk associated with variation in the private agents’ perception on the level of uncertainty”. State-uncertainty preferences amount to assuming that a given level of consumption will yield a higher level of utility the lower is the level of uncertainty perceived by consumers. Furthermore, empirical evidence from three main European economies in the transition period to the euro provides empirical support for the model |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:ucm:doicae:0917&r=upt |
| By: | Marc-Arthur Diaye (ENSAI et Centre d'Economie de la Sorbonne); François Gardes (Centre d'Economie de la Sorbonne - Paris School of Economics); Christophe Starzec (Centre d'Economie de la Sorbonne) |
| Abstract: | This paper contributes to the discussion of the compatibility of consumers' behavior in "real" life with GARP. Within expenditure panel data we observe a relatively low rate of violation (240 out of 3630 households). We show that these violations do not imply an "irrational" behavior of the agents, but can be attributed to a change in the agents' choice conditions during a period of time, which includes a shift from a centrally planned towards a market oriented economy. |
| Keywords: | GARP, shadow prices. |
| JEL: | C14 D11 D12 |
| Date: | 2009–04 |
| URL: | http://d.repec.org/n?u=RePEc:mse:cesdoc:09020&r=upt |
| By: | Eric VERNIER (labrii, ULCO); Aymeric BOUCHIE DE BELLE (labrii, ULCO) |
| Abstract: | Dans un contexte de crise, il est facile de perdre ses repères, et les comportements irrationnels actuels, la panique généralisée des investisseurs le démontrent. Alors que de nombreuses cessations de paiement des ménages américains étaient constatées depuis plusieurs mois, de nombreux investisseurs ont continué à acheter des produits liés au marché des subprimes. Une lecture de l’histoire financière souligne le caractère récurrent et global des anomalies de marché. Le présent article cherche à savoir en quoi de bons résultats financiers passés influencent l’aversion au risque d’un investisseur. In a context of crisis, it is easy to lose its points of reference; the current irrational behaviours and the general panic of investors demonstrate it. While for sevenal months, many american households have been unable to meet their financial obligation, some investors have kept on buying financial products linked to the market of the subprimes. An interpretation of the financial history underlines the recurring and global character of the markets' abnormalities. The present article tries to know how good financial results achieved in the past can influence the investor’s risk aversion. |
| Keywords: | irrational behaviors, financial history, investor’s risk aversion |
| JEL: | G14 G19 O16 |
| Date: | 2009–02 |
| URL: | http://d.repec.org/n?u=RePEc:rii:riidoc:209&r=upt |
| By: | Epstein, Gil S. (Bar-Ilan University); Gang, Ira N. (Rutgers University) |
| Abstract: | In this paper we try to understand the phenomena whereby a large proportion of the population evades tax payments. We present a model which incorporates elements from the theory of information cascades with the standard model of tax evasion and analyze the connection between the decision of a potential tax evader, the number of tax evaders and the number caught in previous periods. General conditions exist under which any expected utility maximizing tax evaders will decide to emulate other tax evaders. |
| Keywords: | tax evasion, uncertainty, information cascades |
| JEL: | H26 H31 D82 |
| Date: | 2009–04 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp4153&r=upt |
| By: | Massimo Guidolin; Francesca Rinaldi |
| Abstract: | The 2007-2008 financial crises has made it painfully obvious that markets may quickly turn illiquid. Moreover, recent experience has taught us that distress and lack of active trading can jump "around" between seemingly unconnected parts of the financial system contributing to transforming isolated shocks into systemic panic attacks. We develop a simple two-period model populated by both standard expected utility maximizers and by ambiguity-averse investors that trade in the market for a risky asset. We show that, provided there is a sufficient amount of ambiguity, market break-downs where large portions of traders withdraw from trading are endogeneous and may be triggered by modest re-assessments of the range of possible scenarios on the performance of individual securities. Risk premia (spreads) increase with the proportion of traders in the market who are averse to ambiguity. When we analyze the effect of policy actions, we find that when a market has fallen into a state of impaired liquidity, bringing the market back to orderly functioning through a reduction in the amount of perceived ambiguity may cause further reductions in equilibrium prices. Finally, our model provides stark indications against the idea that policy makers may be able to "inflate" their way out of a financial crisis. |
| Keywords: | Risk ; Capital assets pricing model ; Financial crises ; Federal Reserve System |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2009-20&r=upt |
| By: | Dohmen, Thomas (ROA, Maastricht University); Falk, Armin (University of Bonn); Huffman, David (Swarthmore College); Marklein, Felix (Federal Ministry of Finance); Sunde, Uwe (University of St. Gallen) |
| Abstract: | Many economic decisions involve a substantial amount of uncertainty, and therefore crucially depend on how individuals process probabilistic information. In this paper, we investigate the capability for probability judgment in a representative sample of the German population. Our results show that almost a third of the respondents exhibits systematically biased perceptions of probability. The findings also indicate that the observed biases are related to individual economic outcomes, which suggests potential policy relevance of our findings. |
| Keywords: | long-term unemployment, representative design, hot hand fallacy, gambler's fallacy, probability judgment, bounded rationality, financial decision making |
| JEL: | C90 D00 D10 D80 D81 H00 |
| Date: | 2009–05 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp4170&r=upt |
| By: | Costa, Carlos Eugênio da; Vasconcelos, Jivago X. |
| Abstract: | Verdelhan (2009) shows that if one is to explain the foreign exchange forward premium behavior using Campbell and Cochrane (1999)'s habit formation model one must specify it in such a way to generate pro-cyclical short term risk free rates. At the calibration procedure, we show that this is only possible in Campbell and Cochrane's framework under implausible parameters speci cations given that the price-consumption ratio diverges in almost all parameters sets. We, then, adopt Verdelhan's shortcut of xing the sensivity function (st) at its steady state level to attain a nite value for the price-consumption ratio and release it in the simulation stage to ensure pro-cyclical risk free rates. Beyond the potential inconsistencies that such procedure may generate, as suggested by Wachter (2006), with pro- cyclical risk free rates the model generates a downward sloped real yield curve, which is at odds with the data. |
| Date: | 2009–05–12 |
| URL: | http://d.repec.org/n?u=RePEc:fgv:epgewp:692&r=upt |