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on Utility Models and Prospect Theory |
| By: | Yonatan Aumann |
| Abstract: | Classically, risk aversion is equated with concavity of the utility function. In this work we explore the conceptual foundations of this definition. In accordance with neo-classical economics, we seek an ordinal definition, based on the decisions maker’s preference order, independent of numerical values. We present two such definitions, based on simple, conceptually appealing interpretations of the notion of risk-aversion. We then show that when cast in quantitative form these ordinal definitions coincide with the classical Arrow-Pratt definition (once the latter is defined with respect to the appropriate units), thus providing a conceptual foundation for the classical definition. The implications of the theory are discussed, including, in particular, to the understanding of insurance. The entire study is within the expected utility framework. |
| Keywords: | Risk aversion, Utility theory, Ordinal preferences, Multiple objectives decision making |
| Date: | 2015–06 |
| URL: | http://d.repec.org/n?u=RePEc:huj:dispap:dp686&r=upt |
| By: | Simon Dato; Andreas Grunewald; Daniel Müller |
| Abstract: | This paper provides a comprehensive analysis regarding strategic interaction under expectation-based loss-aversion. First, we develop a coherent framework for the analysis by extending the equilibrium concepts of Koszegi and Rabin (2006, 2007) to strategic interaction and demonstrate how to derive equilibria. Second, we delineate how expectation-based loss-averse players differ in their strategic behavior from their counterparts with standard expected-utility preferences. Third, we analyze equilibrium play under expectation-based loss aversion and comment on the existence of equilibria. |
| Keywords: | Non-Cooperative Games, Expectation-Based Loss Aversion, Reference-Dependent Preferences, Mixed Strategies |
| JEL: | C72 D01 D03 D81 |
| URL: | http://d.repec.org/n?u=RePEc:bon:bonedp:bgse02_2015&r=upt |
| By: | Kramer, Berber |
| Abstract: | A large body of literature suggests that consumers derive utility from gains and losses relative to a reference point. This paper shows that such reference dependence can affect savings in opposite directions depending on whether people face liquidity constraints. Existing models for wealth and intertemporal choice predict that reference dependence reduces savings but these models abstract from liquidity constraints. Introducing a liquidity constraint, I find that reference dependence can increase optimal savings for people without access to credit. Liquidity constraints force them to take part of an income loss in early periods, which may induce those who are reference dependent to concentrate the full loss in early periods and save in order to eliminate future losses. Further, anticipating a liquidity constraint raises the expected level of future consumption and thus the expectations-based reference point for future periods, creating a second savings motive. This underscores the impact that financial market imperfections can have when applying reference-dependent models in low-income settings. |
| Keywords: | Finance, savings, assets, households, microeconomics, Decision making, loss aversion, imperfect financial markets, intertemporal choice, |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:fpr:ifprid:1431&r=upt |
| By: | Demuynck T. (GSBE) |
| Abstract: | We develop a test to verify if every agent from a population of heterogeneous consumers has the same marginal utility of income function. This homogeneous marginal utility of income assumption is often implicitly used in applied demand studies because it has nice aggregation properties and facilitates welfare analysis. If a dataset satisfies our test, we can further identify the common marginal utility of income function. We apply our results using a US cross sectional dataset on food consumption. |
| Keywords: | Hypothesis Testing: General; Semiparametric and Nonparametric Methods: General; Consumer Economics: Empirical Analysis; Welfare Economics: General; |
| JEL: | C12 C14 D12 D60 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:unm:umagsb:2015013&r=upt |
| By: | David B. Johnson; Matthew Webb (University of Calgary) |
| Abstract: | We examine decision making in the context of one sided matching: where individuals simultaneously submit several applications to vacancies, each match has an exogenous probability of forming, but each applicant can only fill one vacancy. In these environments individuals choose among interdependent, rival, uncertain outcomes. We design an experiment that has individuals choose a varying number of interdependent lotteries from a fixed set. We find that: 1) with few choices, subjects make safer and riskier choices, 2) subjects behave in a manner inconsistent with expected utility maximizing behavior. We discuss these findings in the context of college application decisions. |
| Date: | 2015–07–09 |
| URL: | http://d.repec.org/n?u=RePEc:clg:wpaper:2015-12&r=upt |
| By: | Clark, Andrew E. (Paris School of Economics); Senik, Claudia (Paris School of Economics); Yamada, Katsunori (Kindai University) |
| Abstract: | While there is now something of a consensus in the literature on the economics of happiness that income comparisons to others help determine subjective wellbeing, debate continues over the relative importance of own and reference-group income, in particular in research on the Easterlin paradox. The variety of results in this domain have produced some scepticism regarding happiness analysis, and in particular with respect to the measurement of reference-group income. We here use data from an original Internet survey in Japan to compare the results from happiness regressions to those from hypothetical-choice experiments. The trade-off between own and others' income (showing the importance of absolute and relative income) is similar in these two sets of results. This kind of validation of experienced utility via direct comparison with decision utility remains rare in this literature. |
| Keywords: | satisfaction, income comparisons, reference-group income, discrete-choice experiments |
| JEL: | D31 D63 I3 J31 |
| Date: | 2015–07 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp9189&r=upt |
| By: | Jan Bergerhoff; Agnes Vosen |
| Abstract: | Everyone remembers a plot where a disadvantaged individual facing the prospect of failure, spends more effort, turns around the game and wins unexpectedly. Most tournament theories, however, predict the opposite pattern and see the disadvantaged agent investing less effort. We show that ’turn arounds’, i.e. situations where the trailing player spends more effort and becomes the likely winner of the tournament, can be the outcome of a Nash equilibrium when the initial unevenness is known and players have reference-dependent preferences. Under certain conditions, they are the only pure strategy equilibrium. If the initial unevenness is large enough the advantaged player will always invest the most effort. We also show that equilibria in which the player behind catches up without becoming the likely winner do not exist. |
| Keywords: | loss aversion, gain-loss utility, normal distribution, competition |
| JEL: | C72 D63 D44 |
| Date: | 2015–02 |
| URL: | http://d.repec.org/n?u=RePEc:bon:bonedp:bgse03_2015&r=upt |
| By: | A. Y. Klimenko |
| Abstract: | This work considers reasons for and implications of discarding the assumption of transitivity, which (transitivity) is the fundamental postulate in the utility theory of Von Neumann and Morgenstern, the adiabatic accessibility principle of Caratheodory and most other theories related to preferences or competition. The examples of intransitivity are drawn from different fields, such as law, biology, game theory, economics and competitive evolutionary dynamic. This work is intended as a common platform that allows us to discuss intransitivity in the context of different disciplines. The basic concepts and terms that are needed for consistent treatment of intransitivity in various applications are presented and analysed in a unified manner. The analysis points out conditions that necessitate appearance of intransitivity, such as multiplicity of preference criteria and imperfect (i.e. approximate) discrimination of different cases. The present work observes that with increasing presence and strength of intransitivity, thermodynamics gradually fades away leaving space for more general kinetic considerations. Intransitivity in competitive systems is linked to complex phenomena that would be difficult or impossible to explain on the basis of transitive assumptions. Human preferences that seem irrational from the perspective of the conventional utility theory, become perfectly logical in the intransitive and relativistic framework suggested here. The example of competitive simulations for the risk/benefit dilemma demonstrates the significance of intransitivity in cyclic behaviour and abrupt changes in the system. The evolutionary intransitivity parameter, which is introduced in the Appendix, is a general measure of intransitivity, which is particularly useful in evolving competitive systems. Quantum preferences are also considered in the Appendix. |
| Date: | 2015–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1507.03169&r=upt |
| By: | Nævdal, Eric (The Ragnar Frisch Centre for Economic Research) |
| Abstract: | Catastrophic risk is currently a hotly debated topic. This paper contributes to this debate by showing two results. First it shown that the value function in dynamic optimization can have an infinite derivative at some point even if the model specification has functional forms that are finite and without infinite derivatives. In the process it is shown that standard phase diagrams used in optimal control theory contain more information than generally recognized. Second we show that even if the value function has an infinite derivative at some point, it is not correct that this point should be avoided in finite time at almost any cost. The results are illustrated in a simple linear-quadratic fisheries model, but proven for a more general class of growth functions. |
| Keywords: | Catastrophic risk; fisheries; optimal control; shadow prices |
| JEL: | C61 Q22 Q54 |
| Date: | 2015–03–30 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:osloec:2015_008&r=upt |
| By: | Alexia Gaudeul (DFG Research Training Group 1411: The Economics of Innovative Change, Friedrich-Schiller-Universität, Jena) |
| Abstract: | Social lotteries are lotteries that are played along with someone else. The experimental literature indicates that risk attitudes depend on how one's situation in the safe alternative compares to that of a peer. Evaluation of the risky alternative also depends on whether the lottery gives equal payoffs ex-post. Experiments usually present payoffs side-by-side (payoff for me, payoff for the other). This draws attention to inequality in payoffs and thus gives weight to fairness concerns. We consider whether showing own payoff as a share of the total payoff changes risk preferences. Showing total payoffs explicitly draws attention to risk at the level of the pair and may thus moderate dislike for negatively correlated lotteries, as those are less risky at the level of the group. We find that a significant minority of subjects keeps on disliking lotteries that lead to ex-post unequal distributions of payoffs. Subjects also tend to prefer taking a risk rather than obtaining safe but unequal payoff distributions. Beyond reconciling findings from the previous literature, we also discuss differences in sensitivity to the social setting across individuals and the relation between social value orientation in safe and in risky settings. |
| Keywords: | Altruism, Choice under risk, Efficiency, Experiment, Fairness, Inequality aversion, Lotteries, Social lotteries, Social preferences |
| JEL: | C91 D63 D81 |
| Date: | 2015–07–09 |
| URL: | http://d.repec.org/n?u=RePEc:jrp:jrpwrp:2015-010&r=upt |
| By: | Kunte, Sebastian; Wollni, Meike |
| Abstract: | Contract flexibility can be expedient for economic exchange in environments with high ambiguity and risk, but may also encourage opportunistic behavior. We run a modified investment game, including the choice between two different contract designs and asymmetric information about the realized surplus (i.e., hidden knowledge). We examine if Nairobi slum dwellers choose flexible over rigid contracts when interacting in risky environments and whether preferences for contract flexibility are sensitive to the exogenous probability of experiencing a negative shock. We find that most interaction is realized through flexible agreements. Principals offer a higher level of flexibility if the likelihood of a shock is high, relative to the low-risk environment. Agents are somewhat more reluctant to sign rigid agreements when facing the threat of a bad state. While agents and the overall efficiency benefit from higher flexibility, principals always do better by opting for a rigid contract. |
| Keywords: | contract flexibility, risk sharing, hidden knowledge, artefactual field experiment, investment game, Nairobi slums, Kenya, Institutional and Behavioral Economics, Risk and Uncertainty, C72, D82, L14, O12, |
| Date: | 2015–05 |
| URL: | http://d.repec.org/n?u=RePEc:ags:gagfdp:205914&r=upt |
| By: | Massimo Marinacci |
| Abstract: | We study decision problems in which the consequences of the alternative actions depend on states determined by a generative mechanism representing some natural or social phenomenon. Model uncertainty arises as decision makers may not know such mechanism. Two types of uncertainty result, a state uncertainty within models and a model uncertainty across them. We discuss some two-stage static decision criteria proposed in the literature that address state uncertainty in the fi rst stage and model uncertainty in the second one (by considering subjective probabilities over models). We consider two approaches to the Ellsberg-type phenomena that these decision problems feature: a Bayesian approach based on the distinction between subjective attitudes oward the two kinds of uncertainty, and a non Bayesian one that permits multiple subjective probabilities. Several applications are used to illustrate concepts as they are introduced. |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:igi:igierp:553&r=upt |
| By: | ITOH Hideshi |
| Abstract: | We study the decision process of an organization that faces a problem of choosing between the status quo project ("no change") and the new project ("change"). The organization consists of a decision maker and an implementer. The implementer first chooses a costly effort to develop a new project. If it is developed, the decision maker formally selects either the status quo project or the new project. Otherwise, only the status quo project is available (and is selected). The implementer then chooses an implementation effort to execute the selected project. Both the decision maker and the implementer have intrinsic and possibly divergent preferences over two projects that are either status-quo-biased (anti-changer) or change-biased (pro-changer). The owner of the organization must choose one of four feasible organizational forms: both status-quo-biased, both change-biased, a status-quo-biased decision maker and a change-biased implementer, and a change-biased decision maker and a status-quo-biased implementer. We analyze how the organizational form affects the decision maker's project selection, the implementer's implementation motive, and his incentive to develop a new project, and solves for the organization optimal for the unbiased owner. |
| Date: | 2015–07 |
| URL: | http://d.repec.org/n?u=RePEc:eti:dpaper:15082&r=upt |
| By: | Asheim, Geir B. (Dept. of Economics, University of Oslo); Zuber, Stéphane (Paris School of Economics and CNRS) |
| Abstract: | Climate policies have stochastic consequences that involve a great number of generations. This calls for evaluating social risk (what kind of societies will future people be born into) rather than individual risk (what will happen to people during their own lifetimes). As a response we propose and axiomatize probability adjusted rank-discounted critical-level generalized utilitarianism (PARDCLU), through a key axiom that requires that the social welfare order both be ethical and satisfy first-order stochastic dominance. PARDCLU is useful for evaluating intergenerational risks, is ethical in contrast to discounted utilitarianism, and avoids objections that have been raised against other ethical criteria. PARDCLU is shown to handle situations with positive probability of human extinction, and is linked to decision theory by yielding rank-dependent expected utilitarianism - but with additional structure - in a special case. |
| Keywords: | Social evaluation; population ethics; decision-making under risk; critical-level utilitarianism; social discounting |
| JEL: | D63 D71 D81 H43 Q54 Q56 |
| Date: | 2015–02–20 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:osloec:2015_006&r=upt |
| By: | Kei Imakubo (Bank of Japan); Jouchi Nakajima (Bank of Japan) |
| Abstract: | The inflation risk premium is an indicator of uncertainty about future inflation. While a positive premium on inflation risk implies more concern about the upside risk of inflation, a negative premium implies more concern about the downside risk. In Japan the inflation risk premium had been constantly negative over a period of time until the end of 2012, but turned positive in early 2013. This finding suggests that market concerns about future inflation have shifted to the upside risk along with a gradual increase in the expected inflation. |
| Keywords: | Inflation risk premia; Term premia; Term structure |
| JEL: | E31 E43 E52 G12 |
| Date: | 2015–07–09 |
| URL: | http://d.repec.org/n?u=RePEc:boj:bojlab:lab15e04&r=upt |
| By: | Roberto Marfè |
| Abstract: | The recent empirical evidence of a downward sloping term structure of equity risk is viewed as a challenge to many leading asset pricing models. This paper analytically characterizes conditions under which a continuous-time long-run risk model can accommodate the stylized facts about dividend and equity risk, when dividends are a stationary stochastic fraction of aggregate consumption. Such a cointegrating relation makes dividends riskier in the short-run than at medium horizons but also preserves the role of long-run risk: consequently, the model captures both the traditional puzzles, like the high equity premium, as well as the new evidence about the term structure of equity risk. |
| JEL: | C62 D51 D53 G12 G13 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:cca:wpaper:409&r=upt |