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on Utility Models and Prospect Theory |
| By: | Guasoni, Paolo; Huberman, Gur; Ren, Dan |
| Abstract: | Shortfall aversion reflects the higher utility loss of a spending cut from a reference point than the utility gain from a similar spending increase, in the spirit of Prospect Theory's loss aversion. This paper posits a model of utility of spending scaled by a function of past peak spending, called target spending. The discontinuity of the marginal utility at the target spending corresponds to shortfall aversion. According to the closed-form solution of the associated spending-investment problem, (i) the spending rate is constant and equals the historical peak for relatively large values of wealth/target; and (ii) the spending rate increases (and the target with it) when that ratio reaches its model-determined upper bound. These features contrast with traditional Merton-style models which call for spending rates proportional to wealth. A simulation using the 1926-2012 realized returns suggests that spending of the very shortfall averse is typically increasing and very smooth. |
| Keywords: | consumption; endowments; loss aversion; portfolio choice |
| JEL: | G11 G12 |
| Date: | 2014–07 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:10064&r=upt |
| By: | Daniel R. Burghart; Thomas Epper; Ernst Fehr |
| Abstract: | Many studies document failures of expected utility’s key assumption, the independence axiom. Here, we show that independence can be decomposed into two distinct axioms – betweenness and homotheticity – and that these two axioms are necessary and sufficient for independence. Thus, independence can fail because homotheticity, betweenness, or both are violated. Most research has focused on models that assume subjects will violate both axioms or models that assume subjects will satisfy betweenness but violate homotheticity. Our decomposition of independence into betweenness and homotheticity allows us to show, however, that a significant share of subjects obey homotheticity but violate betweenness. Using data from a revealed preference experiment, and without making any parametric assumptions, we show that 1/3 of participants belong in the neglected class of preferences that violate independence but satisfy homotheticity, indicating that betweenness is violated. Another 1/3 of participants satisfy independence. The remaining 1/3 fail both independence and homotheticity and may also fail betweenness. Our results provide useful constraints on future modeling attempts by highlighting, in a non-parametric way, an empirically relevant class of preferences. |
| Keywords: | Revealed preferences, risk preferences, expected utility, independence axiom, betweenness, homotheticity, consumer choice, aggregation |
| JEL: | C91 D11 D12 D83 |
| Date: | 2014–11 |
| URL: | http://d.repec.org/n?u=RePEc:zur:econwp:179&r=upt |
| By: | Karehnke, P. |
| Abstract: | This thesis studies portfolio choice and asset pricing with preferences which go beyond the standard expected utility and mean-variance preferences. The first part of this thesis analyses a decision model in which the decision maker forms endogenous beliefs given his anticipation utility and his ex-post disappointment. Portfolio choice and asset pricing implications of the model are derived and compared to the implications of the standard expected utility framework. The second part of this thesis analyses investors choice when preferences are derived from the first three moments of portfolio returns. We derive and test the conditions under which additional assets can improve the investment opportunity set of investors with mean-variance-skewness preferences. The implications of these preferences for the equilibrium cross-section of asset returns are then analyzed and tested with stock returns. |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:tiu:tiutis:d0a7843a-5bc8-4fa8-97d6-f1284e4514b2&r=upt |
| By: | Lin Zhao (University of Amsterdam); Sweder van Wijnbergen (University of Amsterdam) |
| Abstract: | We apply utility indifference pricing to solve a contingent claim problem, valuing a connected pair of gas fields where the underlying process is not standard Geometric Brownian motion and the assumption of complete markets is not fulfilled. First, empirical data are often characterized by time-varying volatility and fat tails; therefore we use Gaussian GAS (Generalized AutoRegressive Score) and GARCH models, extending them to Student's t-GARCH and t-GAS. Second, an important risk (reservoir size) is not hedgeable. Thus markets are incomplete which also makes preference free pricing impossible and thus standard option pricing inapplicable. Therefore we parametrize the investor's risk preference and use utility indifference pricing techniques. We use Lease Square Monte Carlo simulations as a dimension reduction technique. Moreover, an investor often only has an approximate idea of the true probabilistic model underlying variables, making model ambiguity a relevant problem. We show empirically how model ambiguity affects project values, and importantly, how option values change as model ambiguity gets resolved in later phases of the projects considered. We show that traditional valuation approaches will consistently underestimate the value of project flexibility and in general lead to overly conservative investment decisions in the presence of time dependent stochastic structures. |
| Keywords: | real options; time varying volatility and fat tails; GAS models; model ambiguity; decision making in incomplete markets; utility indifference pricing |
| JEL: | C61 D81 G01 G31 G34 Q40 |
| Date: | 2014–12–01 |
| URL: | http://d.repec.org/n?u=RePEc:dgr:uvatin:20140149&r=upt |
| By: | Davide Pettenuzzo (Department of Economics, Brandeis University); Francesco Ravazzolo (Norges Bank (Central Bank of Norway) and BI Norwegian Business School) |
| Abstract: | We propose a novel Bayesian model combination approach where the combination weights depend on the past forecasting performance of the individual models entering the combination through a utility-based objective function. We use this approach in the context of stock return predictability and optimal portfolio decisions, and investigate its forecasting performance relative to a host of existing combination schemes. We find that our method produces markedly more accurate predictions than the existing model combinations, both in terms of statistical and economic measures of out-of-sample predictability. We also investigate the role of our model combination method in the presence of model instabilities, by considering predictive regressions that feature time-varying regression coecients and stochastic volatility. We find that the gains from using our model combination method increase significantly when we allow for instabilities in the individual models entering the combination. |
| Keywords: | Bayesian econometrics, Time-varying parameters, Model combinations, Portfolio choice |
| JEL: | C11 C22 G11 G12 |
| Date: | 2014–11–24 |
| URL: | http://d.repec.org/n?u=RePEc:bno:worpap:2014_15&r=upt |
| By: | Tristan Le Cotty (CIRED, Centre de Coopération Internationale en Recherche Agronomique pour le Développement); Elodie Maitre D'hotel (Marchés, Organisations, Institutions et Stratégies d'Acteurs, INRA; Centre de Coopération Internationale en Recherche Agronomique pour le Développement); Raphael Soubeyran (Laboratoire Montpelliérain d'Economie Théorique et Appliquée, INRA); Julie Subervie (Laboratoire Montpelliérain d'Economie Théorique et Appliquée, INRA) |
| Abstract: | Abstract This paper investigates the reasons why African farmers differ in storage behavior and estab- lishes a causal link between farmers’ time and risk preferences and storage.We first provide a styl- ized onfarmstorage model inwhich impatience and risk aversion interact in the storage decision process. We show that impatience decreases grain storage whereas risk aversion may increase or decrease the quantity of grain stored from the harvest season to the lean season. We then test these propositions using original data on agricultural decisions, which we have collected from 1,500 farmers in two regions of Burkina Faso, who were also asked hypothetical questions about risk aversion and time discounting. Parameterized to our data, the model predicts that stored quantities decrease with impatience and increase with risk aversion. We then turn to an econo- metric analysis and provide an identification strategy which tackles a sample selection issue in our data. Consistently with the model, we find a negative impact of impatience and a positive impact of risk aversion on the storage level. The effects are statistically significant and robust to various measures of time and risk preferences. This paper provides one of the first set of field evi- dence that links risk aversion and time discounting to observed agricultural decisions. |
| Keywords: | agriculture, discount rate, risk aversion, storage, durée de stockagegestion de stock, aversion au risque, prix agricoleburkina faso, afrique occidentale |
| JEL: | Q13 Q12 Q16 Q18 D03 D14 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:inr:wpaper:276407&r=upt |
| By: | Vieider, Ferdinand M.; Beyene, Abebe; Bluffstone, Randall; Dissanayake, Sahan; Gebreegziabher, Zenebe; Martinsson, Peter; Mekonnen, Alemu |
| Abstract: | Risk-aversion has generally been found to decrease in income. This may lead one to expect that poor countries will be more risk-averse than rich countries. Recent comparative findings with students, however, suggest the opposite, giving rise to a risk-income paradox. This paper tests this paradox by measuring the risk preferences of more than 500 household heads spread over the highlands of Ethiopia and finds high degrees of risk tolerance. The paper also finds risk tolerance to increase in income proxies, thus completing the paradox. Using exogenous proxies, the paper concludes that part of the causality must run from income to risk tolerance. The findings suggest that risk preferences cannot be blamed for the failure to adopt new technologies. Alternative explanations are discussed. |
| Keywords: | Statistical&Mathematical Sciences,Economic Theory&Research,Labor Policies,Insurance&Risk Mitigation,Hazard Risk Management |
| Date: | 2014–12–01 |
| URL: | http://d.repec.org/n?u=RePEc:wbk:wbrwps:7137&r=upt |
| By: | Gaurab Aryal |
| Abstract: | In this paper I study nonparametric identification of a screening model when consumers have multivariate private information about their preferences. In particular, I consider the multiproduct nonlinear pricing model developed by Rochet and Chon\'e (1998), and determine conditions under which the cost function and the joint density of preferences are identified. When the utility function is nonlinear the model cannot be identified with data from only one market. If there is, however, an exogenous binary cost shifter then we can identify the utility function. Moreover, if we have some consumer characteristics that affect the utility function, then the model is over identified, which leads to a specification test that can be used to check the validity of model. I also characterize all testable restrictions of the model on the data (demand and prices). |
| Date: | 2014–11 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1411.6250&r=upt |
| By: | Pierre Chaigneau; Alex Edmans; Daniel Gottlieb |
| Abstract: | This paper shows that the informativeness principle, as originally formulated by Holmstrom (1979), does not hold if the first-order approach is invalid. We introduce a "generalized informativeness principle" that takes into account non-local incentive constraints and holds generically, even without the first-order approach. Our result holds for both separable and non-separable utility functions. |
| JEL: | D86 J33 |
| Date: | 2014–12 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:20729&r=upt |
| By: | Dafeng Xu |
| Abstract: | This paper incorporates the behavioral labor economic perspective into the traditional Harris-Todaro rural-urban migration model. We study cases in which one's utility is not only determined by his own wage, but also by wages of others. In our theoretical models, rural-urban migration is driven by the expected utility differential, instead of the expected wage differential. We find that the conventional ``Harris-Todaro equilibrium' (in which the rural wage equals the expected urban wage) always exists, but there are two other possible equilibria, in which the rural wage can be either greater or less than the expected urban wage. Moreover, we show that if lower-income players gain utility from the wage differential, i.e., they are altruistic towards higher-income players, and the degree of altruism is sufficiently large, then the two equilibria in which the rural wage differs from the expected urban wage are stable, and the Harris-Todaro equilibrium is not stable. |
| JEL: | O15 P25 D64 |
| Date: | 2014–11 |
| URL: | http://d.repec.org/n?u=RePEc:wiw:wiwrsa:ersa14p536&r=upt |
| By: | Gaffeo, Edoardo; Petrella, Ivan; Pfajfar, Damjan; Santoro, Emiliano |
| Abstract: | There is widespread evidence that monetary policy exerts asymmetric effects on output over contractions and expansions in economic activity, while price responses display no sizeable asymmetry. To rationalize these facts we develop a dynamic general equilibrium model where households’ utility depends on consumption deviations from a reference level below which loss aversion is displayed. State-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption generate competing effects on output and inflation. Contractions face the Central Bank with higher responsiveness of output to interest rate changes, as well as a flatter aggregate supply schedule. |
| Keywords: | asymmetry; business cycle; monetary policy; prospect theory |
| JEL: | D03 D11 E32 E42 E52 |
| Date: | 2014–08 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:10105&r=upt |
| By: | Da Silva, Sergio |
| Abstract: | This essay asserts that the mutual gains accruing from the exchange of goods between siblings can moderate the famous parent-offspring conflict, an issue of interest in evolutionary biology. The rationale combines basic concepts of economics and behavioral genetics, and fills in the gaps of standard economic theory by justifying why trade, ultimately a cooperative endeavor, is possible from egoistic utility maximizers. |
| Keywords: | Parent-offspring conflict, Gains from trade, Economic methodology, Philosophical foundations of economics |
| JEL: | B41 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:60561&r=upt |
| By: | Maria Teresa Vespucci; Marida Bertocchi; Laureano F. Escudero; Stefano Zigrino |
| Abstract: | We present a mathematical model for maximizing the benefit of a price-taker power producer who has to decide the power generation capacity expansion planning in a long time horizon under uncertainty of the main parameters. These parameters are the variable production costs of the power plants already owned by the producer as well as of the candidate plants of the new technologies among which to choose; the market electricity price along the horizon, as well as the price of green certificates and CO2 emission permits; the potential market share that can be at hand for the power producer. These uncertainties are represented in a two stage scenario tree, so the model is a two stage stochastic integer optimization one, subject to technical constraints, market opportunities and budgetarial constraints, whose first stage variables represent the number of new power plants for each candidate technology to be added to the existing generation mix (whose construction has to start in) every year of the planning horizon. The second stage variables (i.e., scenario dependent) are the continuous operation variables of all power plants in the generation mix along the time horizon. We start presenting the maximization of the net present value of the expected profit over the scenarios along the time horizon (i.e., considering the so named risk neutral strategy). Alternatively, we consider different risk averse strategies (i.e., Conditional Value at Risk, Shortfall Probability, Expected Shortage and First- and Second-order Stochastic Dominance constraint integer-recourse strategies). By using a pilot case we report the main results of considering the six strategies under different hypotheses of the available budget, analysing the impact of each risk averse strategy on the expected profit. For that purpose we use a state-of-the-art MIP solver, concluding that 1. the technical advantage of replacing the risk neutral with the risk averse strategies needs a substantial increase in the computing requirements, but it strongly reduces the risk of non-wanted scenarios at a price of a relatively small reduction on the expected profit; 2. the risk averse strategies considered provide consistent solutions, since for all of them the optimal generation mix mainly consists of conventional thermal power plants, for low risk aversion, which are replaced by renewable energy sources plants, as risk aversion increases; 3. it is mandatory to replace the plain use of the solver with ad-hoc decomposition algorithms that have the additional feature of tackling cross-scenario constraints. |
| Date: | 2013 |
| URL: | http://d.repec.org/n?u=RePEc:brg:newwpa:1305_qum&r=upt |
| By: | Jolivet, Grégory (University of Bristol); Turon, Hélène (University of Bristol) |
| Abstract: | We analyse consumers' search and purchase decisions on an Internet platform. Using a rich dataset on all adverts posted and transactions made on a major French Internet platform (PriceMinister), we show evidence of substantial price dispersion among adverts for the same product. We also show that consumers do not necessarily choose the cheapest advert available and sometimes even choose an advert that is dominated in price and non-price characteristics (such as seller's reputation) by another available advert. To explain the transactions observed on the platform, we derive and estimate a structural model of sequential directed search where consumers observe all advert prices but have to pay a search cost to see the other advert characteristics. We allow for flexible heterogeneity in consumers' preferences and search costs. After deriving tractable identification conditions for our model, we estimate sets of parameters that can rationalize each transaction. Our model can predict a wide range of consumer search strategies and fits almost all transactions observed in our sample. We find empirical evidence of heterogenous, sometimes positive and substantially large search costs and marginal willingness to pay for advert hedonic characteristics. |
| Keywords: | consumer search, revealed preferences, individual heterogeneity, price dispersion, internet |
| JEL: | C13 D12 D81 D83 L13 |
| Date: | 2014–11 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp8643&r=upt |
| By: | Welburn, Jonathan (U Wisconsin); Hausken, Kjell (University of Stavanger) |
| Abstract: | Global financial crises have revealed the systemic risk posed by economic contagion. We provide perspectives on the formulation of a game between countries, central banks, banks, firms, households, and financial intergovernmental organizations to model the dynamics between players. We model strategic choices, strategy sets, and utility functions to provide new tools to handle financial crises. The model is illustrated with examples using sensitivity analysis. One country, and two countries, are considered, and we simulate the impacts of random shocks under a variety of assumptions. |
| Keywords: | Contagion; financial risk; game theory; bank; central bank; country; firms; households; intergovernmental organization; consumption; production; capital; default; borrow; lend; financial friction; shock; sensitivity analysis |
| JEL: | A10 |
| Date: | 2014–12–04 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:stavef:2014_022&r=upt |
| By: | Hisa MORISUGI |
| Abstract: | The subjective value of time is the marginal rate of substitution between travel time and travel cost under constant utility or profit level. It is commonly referred to as the monetary appraisal of value of time or the willingness to pay for savings in travel time. This study proposes methods to measure the true value of time from observable demand functions applicable to non-business transport services modelled both for persons and freight. The methods proposed are different from all previous studies in the valuation of value of time which assumed either a specified utility function then applying true VOT under constant utility or a specified demand function applied using VOT under constant demand. This study showed the capability of the proposed methods to measure the components of the value of time, i.e., value of time as a resource and value of time as a commodity calculated independently or combined using observable demand for non-business person trips. The key factor in deriving the VOT in terms of observable demand is the application of the time-extended RoyÂfs identity. The VOT as a resource defined by the marginal substitution ratio of transport cost and travel time is expressed as the observable transport demand and its derivatives. In deriving the VOT as a commodity, tx is a measure of disutility of traveling. VOT as a commodity varies depending on the mode, length of trip, destination, timing, among other, contrary to the VOT as a resource, which is fix regardless of those mentioned transport characteristics. The total VOT is the combination of the VOT as a resource and VOT as a commodity. Two methods are shown on how to measure the time savings benefits per VOT component in terms of observable Marshallian demand and VOT. The first method is by expressing the Marshallian demand with adjustment of the marginal utility ratio of income, . The second method is by expressing the compensated demand in terms of observable Marshallian demand. As it is the Hicksian compensated demand and VOT that need to be measured, this study succeeded in deriving the time extended Slutsky equations that relates the compensated demand and VOT to the observable Marshallian demand and VOT. The result of non-business freight trips is exactly identical to the case of VOT as a commodity for non-business person trips. The discussion of VOT for business person and freight trips will not included due to the space limit. |
| Keywords: | value of time as a resource; value of time as a commodity; value of time for freight trips; time saving benefit; R |
| Date: | 2014–11 |
| URL: | http://d.repec.org/n?u=RePEc:wiw:wiwrsa:ersa14p395&r=upt |
| By: | Halkos, George; Kevork, Ilias; Tziourtzioumis, Chris |
| Abstract: | In this paper we investigate the minimization process of the exact cost function for a continuous review (Q,R) inventory model with non-negative reorder point and fixed lead-time. Backorders are allowed and the unit shortage cost is used to determine the expected annual shortage cost. Provided that the lead-time demand has J-shaped or unimodal distribution satisfying specific assumptions we derive the general condition when the minimum cost is attained at a positive reorder point or at a reorder point equal to zero. Based on this condition a general algorithm is developed. Some numerical experimentation based on this algorithm using parameter values from the relevant literature indicates that with large demand uncertainty measured by the coefficient of variation the optimal inventory policies lead to excessively large orders and zero reorder points. |
| Keywords: | Inventory; Continuous review model; Exact cost function; Convexity; Cost parameter values; General algorithm. |
| JEL: | C10 C61 C63 M11 M21 |
| Date: | 2014–12–11 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:60545&r=upt |
| By: | Behrens, Kristian; Kanemoto, Yoshitsugu; Murata, Yasusada |
| Abstract: | We generalize the formulae for welfare changes by Arkolakis, Costinot, and Rodríguez-Clare (2012) and Melitz and Redding (2014a) to allow for various cardinalizations of the subutility functions for varieties. Despite the same macro restrictions and the same equilibrium allocations, our new formula coincides with the original ones if and only if the number of varieties is invariant to foreign shocks. When product diversity responds to foreign shocks, different cardinalizations generate different welfare changes, thus revealing a fundamental difficulty in quantifying welfare gains implied by new trade models. |
| Keywords: | cardinalization; new trade models; product diversity; subutility function; welfare gains from trade |
| JEL: | F11 F12 |
| Date: | 2014–11 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:10255&r=upt |