Expected Utility Framework Research Articles

Regional variation in participation in private tutoring and the role of education system features

The use of private tutoring to enhance academic outcomes has proliferated across the globe over recent decades. Despite increased scholarly interest in these so-called shadow education activities, the understanding of how education system features relate to the prevalence of shadow education is relatively limited. Moreover, regional variation of private tutoring within countries remains largely overlooked. This study exploits the federalist structure of Switzerland's education system to investigate how education system features incentivise or discourage participation in private tutoring. Based on a subjective expected utility framework and drawing on data from two large-scale assessment studies, the analyses reveal a substantial regional variation in participation rates in private tutoring. Multilevel regression models provide evidence that the institutional modalities of selection into general secondary education contribute to this variation and the social inequalities in the use of private tutoring.

Optimal insurance deductibles under limited information

When determining the optimal deductible level for an insurance policy, a policyholder faces two limitations. First, uncertainty arises from the randomness of future losses. Second, the opacity of the functional forms of the policyholder's loss distribution and utility function contributes to additional limitations. While the academic literature focuses on the former, we additionally include limited information on these functional forms in our model setting to reflect real-world decision-making. That is, we draw on an expected utility framework and analyze the relationship between optimal deductible levels under limited and full information. We also derive several decision rules under limited information in order to approximate the optimal deductible level under full information. To support real-world decision-making, these rules could be easily implemented in an online decision aid offered by an insurance broker, a comparison portal for insurance contracts or a consumer protection agency.

Health, Longevity, and Welfare Inequality of Older Americans

Abstract We estimate the distribution of well-being among the older U.S. population using an expected utility framework that incorporates differences in consumption, leisure, health, and mortality. We find large disparities in welfare that have increased over time. Incorporating the cost of living with poor health into elderly welfare substantially increases the overall inequality. Disparity measures based on cross-sectional income or consumption underestimate the growth in aggregate welfare inequality. Moreover, health is a better indicator of an individual's relative welfare position than income or consumption.

Behavioral Heuristics of Chinese Education insight into the worlds largest education market through behavioral economics

Reflections upon the acuteness of human intuitive decisions have spurred explorations of interest in behavioral heuristics. While the field has successfully rationalized unexpected outcomes in dissonance against the standard expected utility framework, the path to which its seeming intangibilities make utilitarian contributions toward behaviors and interactions within economies is still yet to be endeavored. Such studies received particularly little attention in China, where awareness of systematic behavioral biases remains limited to the majority of the public, hindering the efficiency of the countrys efforts toward economic development. This dissertation reviews the education system of China, an imperative mechanism, yielding millions whose capabilities and propensities define the prosperity of the world ahead. Through personal experience, a hypothesis was formed around hyperbolic preferences, cognitive dissonance, and the decoy effect. Combining the rigors of survey and the humanistic nature of ethnography, primary research was conducted with students from a district key high school in Shanghai. Results evidently showed students tendencies to overvalue one-dimensional test scores while overlooking the potential for un-materialized skills, as well as their nonperformance of creative or critical abilities. Meanwhile, the uprise of international options (AP, IB, A-level, etc.) induced even higher levels of dependence on local education amongst non-international students, as a result of asymmetric information, deepening their oblivion to potential misjudgments due to cognitive bias.

Flight to quality and portfolio diversification under ambiguity of correlation

We argue that ambiguous correlation between asset payoffs plays an important role in the occurrence of “flight to quality”, which in some circumstances leads investors with incomplete information to portfolio under-diversification. In this paper, we consider a multi-asset economy with four types of investors who have heterogeneous beliefs on correlation coefficients, and in which ambiguity-averse traders make decisions in a maxmin expected utility framework. A unique general equilibrium presents in four scenarios according to the dispersion of asset quality. We define a measure to gauge the degree of portfolio under-diversification, with which we show that correlation ambiguity will drive less-informed investors to hold a nondiversified portfolio if the correlation coefficient is negative, while a positive correlation drives some less-informed investors to hold a fully diversified portfolio.

Plant growth stages and weather index insurance design

AbstractGiven the assumption that weather risks affect crop yields, we designed a weather index insurance product for soybean producers in the US state of Illinois. By separating the entire vegetation cycle into four growth stages, we investigate whether the phase-division procedure contributes to weather–yield loss relation estimation and, hence, to basis risk mitigation. Concretely, supposing stage-variant interaction patterns between temperature-based weather index growing degree days and rainfall-based weather index cumulative rainfall, a nonparametric weather–yield loss relation is estimated by a generalized additive model. The model includes penalized B-spline (P-spline) approach based on nonlinear optimal indemnity solutions under the expected utility framework. The P-spline analysis of variance (PS-ANOVA) method is used for efficient estimation through mixed model re-parameterization. The results indicate that the phase-division models significantly outperform the benchmark whole-cycle ones either under quadratic utility or exponential utility, given different levels of risk aversions. Finally, regarding hedging effectiveness, the expected utility ratio between the phase-division contract and the whole-cycle contract, and the percentage changes of mean root square loss and variance of revenues support the proposed phase-division contract.

Bowley Insurance with Expected Utility Maximization of the Policyholders

This article studies the Bowley solution for a sequential game within the expected utility framework. We assume that the policyholders are expected utility maximizers and there exists a representative policyholder who faces a fixed loss with given probability and no loss otherwise. This policyholder selects the optimal indemnity function in response to the pricing kernel set by the insurer. Knowing the policyholder’s choice of indemnity function, the insurer adjusts the pricing kernel to maximize its expected net profit. This pricing kernel is of our central interest in this article, and in our setting the pricing kernel can be evaluated via the safety loading factor in an expected value premium principle. For a wide class of utility functions, we show that the optimal safety loading factor increases with respect to both the policyholder’s risk aversion level and the probability of zero loss. We also show that the insurance contract corresponding to the Bowley solution is Pareto dominated in the sense that both parties’ interests can be further improved, which shows the inefficiency of the Bowley solution. Some numerical examples are presented to illustrate the main results, and it is shown that both the policyholder and insurer can strictly benefit from the Bowley solution.

Conservation intensification under risk: An assessment of adoption, additionality, and farmer preferences

AbstractConservation practices used on agricultural cropland can provide important ecosystem services. The United States relies largely on voluntary programs to incentivize adoption of conservation practices, but the success of these efforts relies on good program design. We use a choice experiment to evaluate farmers' willingness to adopt more intensive in‐field conservation practices (continuous no‐till, conservation crop rotation, cover crops, and variable rate application of inputs) using a nonlinear extended expected utility framework that incorporates risk under a conservation contract. We contribute to the literature by providing insights regarding producers' preference for incentive payment mechanism (federal program or carbon market) and the incentive payment needed to induce additionality and practice continuity. We find that although an additional payment might be needed to promote practice continuity among farmers who have previously adopted cover crops, in the case of continuous no‐till, adopters might be willing to forgo additional payment to continue benefiting from the use of this practice. Our results also revealed producers prefer conservation contracts accruing higher off‐farm environmental benefits and federally administered over carbon market programs. This is an important result given an increased public interest in climate change and new proposed carbon mitigation policies and private carbon market initiatives.

Asymptotic properties of generalized shortfall risk measures for heavy-tailed risks

We study a general risk measure called the generalized shortfall risk measure, which was first introduced in Mao and Cai (2018). It is proposed under the rank-dependent expected utility framework, or equivalently induced from the cumulative prospect theory. This risk measure can be flexibly designed to capture the decision maker's behavior toward risks and wealth when measuring risk. In this paper, we derive the first- and second-order asymptotic expansions for the generalized shortfall risk measure. Our asymptotic results can be viewed as unifying theory for, among others, distortion risk measures and utility-based shortfall risk measures. They also provide a blueprint for the estimation of these measures at extreme levels, and we illustrate this principle by constructing and studying a quantile-based estimator in a special case. The accuracy of the asymptotic expansions and of the estimator is assessed on several numerical examples.

Semivariance below the maximum: Assessing the performance of economic and financial prospects

This paper examines the ordering of economic and financial prospects using a rescaled semivariance below the maximum (SVBMax). This indicator is consistent with stochastic dominance (SD) until order three, but is distinct from any expected utility framework, both in terms of construction and in terms of economic implications, despite an apparent formal similarity with the quadratic expected utility framework. SVBMax is able to deal with economic puzzles such as the restaurant puzzle or Rabin’s paradox. SVBMax also provides a consistent alternative performance measure to popular measures such as the Sharpe ratio, the Omega ratio, or lower partial moments with exogenous thresholds. Compared to almost stochastic dominance, SVBMax is devoid of the drawbacks associated with the determination of violation areas. SVBMax can also replace the Aumann-Serrano and Foster-Hart riskiness indicators, which do not conform to third order SD. Further, SVBMax can provide a way of reaching an optimal diversification of stock portfolios. Besides, we also show that SVBMax is consistent with mean-variance-skewness preferences.

Prospect theory and a manager's decision to trade a blind principal bid basket

We analyze asset managers' decisions to execute substantial baskets of stocks. Such transactions can be executed in two ways. The first method is through blind auctions with unique features known as blind principal bids (BPBs). The manager learns the trading cost once the auction process determines the commission. The second method is to use an agency trade. In this case, the asset manager faces an actual trading cost that is unknown before execution due to market impact uncertainty. Using proprietary data, we investigate the manager's choice between BPBs and agency trade in a natural experiment with large monetary stakes. The volume traded in each sample basket is significant, which can amount to over 0.5% of the NYSE daily share volume. Our findings show that managers' behavior is more consistent with prospect theory than the expected utility framework. When asset managers trade BPB baskets, they are reluctant to realize the potential higher cost of agency trade and opt for the fixed cost of BPBs instead. Thus, our results complement the literature on the disposition effect by demonstrating that managers' trading cost decisions exhibit “play it safe” behavior.

Hope as a Source of Grit

Psychologists and philosophers have argued that the capacity for perseverance or “grit” depends both on willpower and on a kind of epistemic resilience. But can a form of hopefulness in one’s future success also constitute a source of grit? I argue that substantial practical hopefulness, as a hope to bring about a desired outcome through exercises of one’s agency, can serve as a distinctive ground for the capacity for perseverance. Gritty agents’ “practical hope” centrally involves an attention-fueled, risk-inclined weighting of two competing concerns over action: when facing the decision of whether to persevere, hopeful gritty agents prioritize the aim of choosing a course of action which might go very well over that of choosing a course of action which is very likely to go fairly well. By relying on the notion of a “risk-inclined attentional pattern” as a dimension of gritty agents’ practical hope, we can explain that form of hope’s contribution to their motivation and practical rationality, especially on a risk-weighted expected utility framework. The upshot is a more pluralistic view of the sources of grit.

The impact of fractional trading on risk aversion for non-professional investors

We study the impact of fractional trading (FT) on non-professional investors' decision-making under uncertainty. Using the expected utility framework, we show that with the recent easiness to trade in stock markets and with the option to buy or sell a fraction of a share of a stock or ETF (exchange-traded fund), the risk appetite of non-professional investors might have gone up, increasing market participation and demand for stocks. Furthermore, we show that this change in the non-professional investor's risk aversion behavior varies by household income levels. Based on constructed probabilities, we estimate that approximately 83 billion dollars have been newly invested in stock market post-FT. Our results suggest that easy access to trade stocks and FT allows households with lower discretionary income a new tool to diversify their portfolio and participate in the stock markets by investing in different stocks and ETFs while at the same time having a significant impact on the stocks' price levels and price dynamics observed in the markets.

Corruption and Self-Sabotage in Sporting Competitions – An Experimental Approach to Match-Fixing Behavior and the Influence of Deterrence Factors

This study investigates match-fixing employing a 2-player contest in an experimental setting. Subjects compete in a real-effort task and are bribed onetime to self-sabotage. Based on Becker’s deterrence hypothesis, the effectiveness of deterrent factors is analyzed via different treatments applying an expected utility framework. Results show that the majority of participants do not maximize their monetary payoff, that increasing detection probability has a higher deterring effect on bribe acceptance compared to severity of monetary punishment, and that participants with lower performance levels were more likely to accept bribes. Implications are derived for sport governing bodies to operate against match-fixing.

Managing Risk in Well Placement Optimization within an Expected Utility Framework

Summary Well placement optimization is one of the most crucial tasks in the petroleum industry. It often involves high risk in the presence of geological uncertainty due to a limited understanding of the subsurface reservoir. Well placement optimization is different from decision selection as countless alternatives are impossible to be enumerated in a decision model (such as the mean-variance model). In many practical applications, the decision criterion of well placement optimization is based on maximizing the risk-adjusted value (mean-variance optimization) to capture different risk attitudes. This approach regards variance as the measure of risk, and it is performed under the expected utility framework. However, investors only dislike the downside volatility below a certain benchmark. The downside-risk approach has been discussed in previous studies, in this paper, it will be introduced in the well placement optimization and discussed under the expected utility framework. It is demonstrated in a synthetic reservoir model with the consideration of spatial heterogeneity, and the comparison between the downside-risk optimization and mean-variance optimization is also presented in this example. The observation implies that well placement optimization is heavily influenced by individuals’ preference to risk. The downside-risk optimization outperforms the mean-variance optimization because it explicitly assesses risk and does not penalize high outcomes.

On the impact of low interest rates on common withdrawal rules in old age

Ensuring a desired standard of living in retirement has been strongly challenged by increasing life expectancy, and simultaneously by the current and possibly long-lasting low interest environment. In contrast to literature in this field which claims annuitization of wealth being a vital part of retirement planning, many people manage their retirement savings and withdrawal policy during the retirement period independently. To this end, several easily applicable self-managed withdrawal rules are commonly recommended by financial advisors. We cast doubt on the viability of these self-managed withdrawal rules, particularly in an environment with increasing life expectancies and low interest rates. Further, we show that a mixed rule which combines the fixed percentage and the remaining lifetime rule can significantly improve retirees' welfare in an expected utility framework compared to other simple self-managed withdrawal rules. The results provide important insights for revising common recommendations by financial advisors, designing retirement products, and regulation.

Publishing While Female: are Women Held to Higher Standards? Evidence from Peer Review

Abstract Female authors are under-represented in top economics journals. In this paper, I investigate whether higher writing standards contribute to the problem. I find that (i) female-authored papers are 1%–6% better written than equivalent papers by men; (ii) the gap widens during peer review; (iii) women improve their writing as they publish more papers (but men do not); (iv) female-authored papers take longer under review. Using a subjective expected utility framework, I argue that higher writing standards for women are consistent with these stylised facts. A counterfactual analysis suggests that senior female economists may, as a result, write at least 5% more clearly than they otherwise would. As a final exercise, I show tentative evidence that women adapt to biased treatment in ways that may disguise it as voluntary choice.

Behavioral finance and the architecture of the asset management industry

The standard portfolio approach assumes that investors maximize expected utility, and that the Markowitz mean–variance standard portfolio optimization approach can be applied. Behavioral research, however, indicates that investors’ behavior with respect to risk or uncertainty is not consistent with expected utility. Notably, decision makers transform probabilities. Most of the academic literature integrating those aspects, however, focuses on so-called financial market anomalies but does not focus on the structural impact those behavioral aspects might have, notably in terms of industrial organization of the asset management industry. This paper provides a survey of the asset management industry and argues that the architecture of the asset management industry is inconsistent with the standard expected utility framework. The origin of the industrial organization of the asset management industry stems from the convexity of the flow–performance relationship, which is due to prospect theory effects. The convexity of the flow–performance relationship explains the inflation of mutual funds and fund families, a phenomenon inconsistent with the Mutual Fund Separation Theorem.

Demand for insurance with nonadditive probabilistic beliefs

ABSTRACTThis work examines optimal demand for insurance coverage when the insured has nonadditive subjective probability beliefs about loss uncertainty. By showing the equivalent conditions of Jensen's inequality under the Choquet expected utility framework, we not only provide the threshold on the insurance premium for Mossin's theorem to hold but also explore the joint effect of both risk aversion and uncertainty aversion on optimal insurance demand.

Charity hazard and the flood insurance protection gap: An EU scale assessment under climate change

The flood insurance protection gap, the level of uninsured flood risk, is a problem faced by many European countries and is expected to increase due to climate change. In some countries a cause of low demand for flood insurance is the crowding out of private insurance uptake due to the anticipation of government compensation for uninsured damage, a phenomenon known as charity hazard. This study applies a partial equilibrium model of flood insurance markets to explore the extent of charity hazard and the insurance protection gap for EU-countries until 2050. For this analysis, we apply an expected utility framework with insurance purchase decision functions that capture the probability, ambiguity and extent of government compensation. By accounting for country-level insurance systems and government compensation types, as well as regional flood risk, we aim to assess how charity hazard develops under different conditions. The extent of charity hazard decreases with uncertainty of government compensation, as well as with higher flood risk. Considering current and future conditions, the highest impact of charity hazard is observed in regions of Germany and Italy. The projected insurance protection gap is highest in Germany, followed by Spain, Poland and Italy, and is expected to grow towards 2050.