Standard Expected Utility Model Research Articles

Disentangling risk aversion and loss aversion in first-price auctions: An empirical approach

We develop a model that combines risk averse preferences with anticipated loss aversion to explain bidding in induced value first-price auctions. In particular, we allow bidders to be heterogeneous in risk aversion and loss aversion. We first show that risk aversion and loss aversion both induce ‘overbidding’ with respect to the standard expected utility model without risk and loss aversion. We then identify the distribution of risk aversion and loss aversion coefficients and develop a Bayesian method to estimate the model primitives, augmenting bidder-specific risk and loss coefficients. Our method predicts the data well, and the counterfactual analysis shows that loss aversion explains 65 ∼ 86 percent of overbidding in the data.

A Dynamic Quantile Model for Distinguishing Intertemporal Substitution from Risk Aversion

This paper uses a consumption-based dynamic quantile preference model to estimate the elasticity of intertemporal substitution (EIS) across different levels of risk attitude. In the quantile model, the risk attitude is captured by the quantile and is, therefore, separable from the EIS. This is an advantage with respect to the standard expected utility model, under which risk attitude and EIS are necessarily linked. We derive the quantile Euler equation from the dynamic problem, and use disaggregated consumption data from the Nielsen Consumer Panel together with recently developed instrumental variables quantile regression for nonlinear models to estimate the corresponding EIS across specified quantiles. The empirical results document evidence of heterogeneity in the EIS for different levels of risk attitude, as well as the presence of negative estimates on part of the distribution. The negative estimates help to shed light and reconcile recent results in the literature documenting strong selective reporting, where negative and insignificant EIS estimates are too often discarded.

Outcome Uncertainty, Fan Travel, and Aggregate Attendance

The classical Uncertainty of Outcome Hypothesis (UOH) informs economists’ understanding consumer decisions to attend sporting events and models of team revenue generation. Coates, Humphreys and Zhou (2014) developed a reference dependent preference based consumer choice model under uncertainty to motivate the UOH in which loss-averse consumers prefer games with certain outcomes. We develop an alternative model based on a standard expected utility model of fan behavior which incorporates fans’ decisions to travel to away games and aggregates decisions across local and visiting fans. This model generates predictions consistent with the classical UOH and concave team and league-wide total revenue functions.

Threshold Theory – modelling risk attitude

Abstract In this paper we offer an alternative framework for examining why risk matters in the decisions of economic agents, and how the agent’s risk attitude affects his decisions. This “Threshold Theory” framework is based on a real options approach and the observation that in many situations an agent faces one or more thresholds in the payoff function. These thresholds influence the agent’s risk attitude. The theory’s predictions help to explain many anomalies that the standard expected utility model cannot. Threshold Theory can also model behavior in contexts such as individual investor decisions, corporate governance and other agency problems. Further, we examine CEO decisions as a function of time to the CEO’s retirement to test predictions of the Theory.

Is Expected Utility an Ex-Hypothesis? Some Implications of Reference-Dependent Expected Utility Model

Rabin and Thaler (2001) declared Expected Utility an ex-hypothesis or a dead parrot alluding to the famous sketch from Monthy Pythons Flying Circus. Following Cox and Sadiraj (2006) and others, one should distinguish between Expected Utility (EU) theory (a purely mathematical theory based on axioms) and Expected Utility models (EU theory plus a given economic interpretation). The most prevalent EU model is one that assumes consequentialism (Rubinstein, 2012). Consequentialism states that the decision maker has a single binary preference relation comparing probability distributions over final wealth levels. Preference relations over wealth changes for different levels of wealth are derived from this single preference relation. EU theory plus consequentialism is referred to as the standard EU model. It is argued that most of the critique against EU is against the standard EU model, or against consequentialism. We replace consequentialism with reference-dependence, retaining the EU hypothesis. Using Sugden (2003) framework, we show that many violations of the standard EU model can be explained assuming this different interpretation. Among the topics considered are: WTA/WTP disparity, preference reversal, complementary symmetry, preference homogeneity, loss aversion, reflection effect and the coexistence of insurance and gambling.

Optimal insurance design of ambiguous risks

We examine the characteristics of the optimal insurance contract under linear transaction costs and an ambiguous distribution of losses. Under the standard expected utility model, we know from Arrow (1965) that it contains a straight deductible. In this paper, we assume that the policyholder is ambiguity averse in the sense of Klibanoff et al. (Econometrica 73(6):1849–1892, 2005). The optimal contract depends upon the structure of the ambiguity. For example, if the set of possible priors can be ranked according to the monotone likelihood ratio order, the optimal contract contains a disappearing deductible. We also show that the policyholder’s ambiguity aversion may have the counterintuitive effect to reduce the optimal insurance coverage of an ambiguous risk.

Prospect Theory and Tax Evasion: A Reconsideration of the Yitzhaki Puzzle

The standard expected utility model of tax evasion predicts that evasion is decreasing in the marginal tax rate (the Yitzhaki puzzle). The existing literature disagrees on whether prospect theory overturns the puzzle. We disentangle four distinct elements of prospect theory and find loss aversion and probability weighting to be redundant in respect of the puzzle. Prospect theory fails to reverse the puzzle for various classes of endogenous specification of the reference level. These classes include, as special cases, the most common specifications in the literature. New specifications of the reference level are needed, we conclude.

Promoting Seismic Retrofit Implementation Through “Nudge”: Using Warranty as a Driver

This article proposes a new type of warranty policy that applies the "nudge" concept developed by Thaler and Sunstein to encourage homeowners in Japan to implement seismic retrofitting. Homeowner adaptation to natural disasters through loss reduction measures is known to be inadequate. To encourage proactive risk management, the "nudge" approach capitalizes on how choice architecture can influence human decision-making tendencies. For example, people tend to place more value on a warranty for consumer goods than on actuarial value. This article proposes a "warranty for seismic retrofitting" as a "nudge" policy that gives homeowners the incentive to adopt loss reduction measures. Under such a contract, the government guarantees all repair costs in the event of earthquake damage to the house if the homeowner implements seismic retrofitting. To estimate the degree to which a warranty will increase the perceived value of seismic retrofitting, we use field survey data from 1,200 homeowners. Our results show that a warranty increases the perceived value of seismic retrofitting by an average of 33%, and an approximate cost-benefit analysis indicates that such a warranty can be more economically efficient than an ex ante subsidy. Furthermore, we address the failure of the standard expected utility model to explain homeowners' decisions based on warranty evaluation, and explore the significant influence of ambiguity aversion on the efficacy of seismic retrofitting and nonanalytical factors such as feelings or trust.

The evolution of hyperbolic discounting: Implications for truly social valuation of the future

We explore the standard expected utility model and alternatives to it. We then examine the behavioral and neurological evidence for hyperbolic discounting. We discuss evidence related to the neurological and behavioral evolution of discounting in non-human animals and in humans. We explore new findings about the importance of sociality in human behavior and the implications for truly social time preference. Finally, we discuss the implications of the neurological evidence on discounting for social environmental valuation, in particular the implications for very long-run decisions such as those involved in climate change mitigation and biodiversity preservation.

Moral markets

Is market exchange solely dependent on selfishness or does other-regarding behavior play any substantial role? This article reviews the philosophical, psychological and neurological basis for moral values, showing that they are consistent and measurable. I demonstrate that values play a role in social interactions, including market exchange. Indeed, market exchange in moderately regulated economies is predicated on the notion that most people, most of the time, behave morally – albeit in the shadow of enforcement. This idea is of ancient origin, but is most clearly articulated in Adam Smith's Theory of Moral Sentiments. The moral nature of social decisions is used to identify modifications of the standard expected utility model, and implications for a value-based approach to human decisions are elucidated for law, regulation, business organization, economic growth, and happiness. The conditions that lead to moral market failures like the Enron debacle are also described. Not only do morals underpin markets, but intriguing new evidence suggests that markets may strengthen moral values.

Asset allocation with distorted beliefs and transaction costs

Abstract In this paper we study the problem of the optimal portfolio selection with transaction costs for a decision-maker who is faced with Knightian uncertainty. The decision-maker’s portfolio consists of one risky and one risk-free asset, and we assume that the transaction costs are proportional to the traded volume of the risky asset. The attitude to uncertainty is modeled by the Choquet expected utility. We derive optimal strategies and bounds of the no-transaction region for both optimistic and pessimistic decision-makers. The no-transaction region of a pessimistic investor is narrower and its bounds lie closer to the origin than that of an optimistic trader. Moreover, under the Choquet expected utility the structure of the no-transaction region is not necessarily a closed interval as it is under the standard expected utility model.

Uncertainty, learning and ambiguity in economic models on climate policy: some classical results and new directions

We present how uncertainty and learning are classically studied in economic models. Specifically, we study a standard expected utility model with two sequential decisions, and consider two particular cases of this model to illustrate how uncertainty and learning may affect climate policy. While uncertainty has generally a negative effect on welfare, learning has always a positive, and thus opposite, effect. The effects of both uncertainty and learning on decisions are less clear. Neither uncertainty nor learning can be used as a general argument to increase or reduce emissions today without studying the specific intertemporal costs and benefits. Considering limits in applying the expected utility framework to climate change problems, we then consider a more recent framework with ambiguity-aversion which accounts for situations of imprecise or multiple probability distributions. We discuss both the impact of ambiguity-aversion on decisions and difficulties in applying such a non-expected utility framework to a dynamic context.

Asset Allocation with Hedge Funds on the Menu

Hedge funds have become an increasingly important asset class in recent years. This paper discusses the asset allocation decision of an investor who is considering investing in hedge funds. We develop a simple procedure that may help in making this decision when the assets consist of a core equity portfolio, the risk-free asset, and a hedge fund. A regime-switching framework is used to model the joint returns of the hedge fund and the equity market. We use monthly intervals so that the regimes can change only at most once a month. Within each regime the returns on the two risky assets are bivariate lognormal with constant parameters. These parameters are estimated from the empirical data. We show how to determine the optimal allocation of an investor, such as a pension plan, to hedge fund assets. Our procedure is based on the maximization of expected utility, and we use different horizons. We restrict the admissible strategies to buy-andhold strategies, so we do not allow for portfolio balancing. We illustrate the procedure with examples. We find that bias in the hedge fund expected return has an important impact on the results. We note that some hedge fund strategies have substantial left-tail risk to which investors may be very averse. This type of risk aversion is not adequately captured by the standard expected utility model, but it could be added as a constraint.

Stocks as Lotteries: The Implications of Probability Weighting for Security Prices

We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with a particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with nonunique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be “overpriced” and can earn a negative average excess return. We argue that our analysis offers a unifying way of thinking about a number of seemingly unrelated financial phenomena. (JEL D81, G11, G12)

Stocks as Lotteries: The Implications of Probability Weighting for Security Prices

We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with non-unique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be overpriced, and can earn a negative average excess return. Our results offer a unifying way of thinking about a number of seemingly unrelated financial phenomena, such as the low average return on IPOs, private equity, and distressed stocks; the diversification discount; the low valuation of certain equity stubs; the pricing of out-of-the-money options; and the lack of diversification in many household portfolios.

Background Risk, Demand for Insurance, and Choquet Expected Utility Preferences

This article deals with demand for insurance with a background risk in a nonprobabilized uncertainty framework, where preferences are represented by a nonadditive model of decision making. The Choquet expected utility model that we use generalizes expected utility and allows for a separation of the attitude towards uncertainty and the attitude towards wealth. When the insurable and the background risk are comonotone, the impact of the background risk on the demand for insurance is related to the attitude towards wealth. In contrast, when the two risks are anticomonotone, the attitude towards uncertainty is determinant. In this case, some of the resulting behaviors cannot be explained by the standard expected utility model.

A message from psychologists to economists: mere predictability doesn’t matter like it should (without a good story appended to it)

Stephen J. Gould (Pittsburgh, 3/3/97) recently defined humans as ‘the primates who tell stories.’ This paper reviews evidence for a more radical definition as ‘the primates whose cognitive capacity shuts down in the absence of a story’ when attempting to incorporate probabilistic information to make a coherent probabilistic inference. Thus, people cannot conform (‘descriptively’) to the standard expected utility (EU) model of economic decision making, given that probabilities often cannot be combined either implicitly or explicitly in the absence of a good, clearly relevant story justifying the combination. Moreover, that inability severely limits the standard EU model for use in prescriptive decision making.

Alternative Models of Choice Under Uncertainty and Demand for Health Insurance

The authors test a standard expected utility model and alternative models about how people evaluate risky prospects using data about individuals' preferences among health insurance plans. A model that assumes people evaluate gains and losses relative to a reference rather than final outcomes, treat gains and losses asymmetrically, and process certain and uncertain outcomes separately provides a better fit than the standard utility model. These findings suggest inertia in health insurance plan choice and that individuals are more responsive to decreases than to increases in the price of insurance. Copyright 1996 by MIT Press.

Wiping the Slate Clean: Individual Response to State Tax Amnesties

State governments in recent years have pursued a variety of novel methods to generate revenues. One approach that has become increasingly popular-and controversial-is the tax amnesty. An amnesty typically gives individuals an opportunity to pay previously unpaid taxes without being subject to the penalties and prosecution that the discovery of evasion normally brings. Since 1981, twenty-eight states have offered some form of tax forgiveness to individuals who have failed to pay all their taxes. However, despite the potential significance of amnesties, they are only now beginning to attract much attention. Most of the discussion of amnesties has focused upon the details of their administration [9; 12; 13; 15]. There have now been some theoretical analyses of the benefits and costs of amnesties [2; 3], and, as information from the state programs has become available, there have also been some examinations of the characteristics of those who participate in amnesties and the factors that cause amnesties.' However, the availability of information from those states that have held an amnesty makes examination of two different issues possible. First, do individuals respond in their amnesty compliance decisions to the incentives introduced by an amnesty? Second, how can states use this information to structure an amnesty that encourages maximum participation and generates maximum revenues? It is the purpose of this paper to examine these issues. A standard expected utility model of individual behavior under uncertainty is developed to analyze the individual's response to an amnesty. This model is used to derive a demand for taxes paid in the amnesty, a demand that depends in large part upon the structural features of the amnesty: are known delinquents allowed to participate, is interest on back taxes reduced, are post-amnesty penalties increased, and are greater funds spent on post-amnesty enforcement? This amnesty tax equation is then estimated using aggregate data from the twenty-eight states that have