Conservative dichotomous choice responses in the active policy setting: DC rejections below WTP

An important feature of a Contingent Value (CV) study is that researchers design a survey that guides respondents to answer dichotomous choice (DC) questions as if they represent once-and-for-all choices. Researchers frequently construct hypothetical markets to satisfy this condition; yet detractors assert that ‘hypotheticality’ leads inevitably to inflated DC responses. For active policy questions, however, some respondents may suspect that a CV informs an actual policy issue; so to reject a DC might induce the policy-maker to reintroduce the policy with a price reduction or a program improvement. With potential incentives to deflate a DC response when policies are active, we locate two types of respondents that represent two different incentives. One class is expected to be able to risk permanent rejection of a waiver from one automobile emissions inspection. This class more frequently rejects a DC value known to improve existing conditions. Another respondent class is expected to be risk averse to defeat of the program or to excessive delay. Predictably, these respondents more frequently accept a DC value that represents a known gain. Conservative DC responses have implications for the use of CV in active policy contexts, opening a role for theory to assist practitioners in these circumstances.      

The Impact of Regret on Exports

We examine optimal production and export decisions of a firm facing exchange rate uncertainty, where the firm's management is not only risk averse but also regret averse, i.e., is characterized by a utility function that includes disutility from having chosen ex post suboptimal alternatives. Experimental and empirical results support the view that managers tend to be regret averse. Under regret aversion a negative risk premium need not preclude the firm from exporting which would be the case if the firm were only risk averse. Exporting creates an implicit hedge against the possibility of regret when the realized spot exchange rate turns out to be high. The regret‐averse firm as such has a greater ex ante incentive to export than the purely risk averse firm. Finally, we use a two‐state example to illustrate that the firm optimally exports more (less) to the foreign country than in the case of pure risk aversion if the low (high) spot exchange rate is more likely to prevail. Regret aversion as such plays a crucial role in determining the firm's optimal allocation between domestic sales and foreign exports.     

Strategy-proof risk sharing

We consider risk sharing problems with a single good and a finite number of states. Agents have a common prior and their preferences are represented in the expected utility form and are risk averse. We study efficient and individually rational risk sharing rules satisfying strategy-proofness, the requirement that no one can ever benefit by misrepresenting his preference. When aggregate certainty holds, we show that “fixed price selections” from Walrasian correspondence are the only rules satisfying efficiency, individual rationality, and strategy-proofness. However, when aggregate uncertainty holds, we show that there exists no rule satisfying the three requirements. Moreover, in the two agents case, we show that dictatorial rules are the only efficient and strategy-proof rules. Dropping the common prior assumption in the model, we show that this assumption is necessary and sufficient for the existence of rules satisfying the three main requirements in the two agents and aggregate certainty case.     

Risk preference interactions between individual farmers and small farmer groups: Experimental evidence from rural Ethiopia

The understanding of risk preference interactions among poor farmers in developing countries has important policy implications, as many programs that aim to alleviate poverty and address risk constraints are provided on a collective basis. We conduct a randomized field experiment in the drought-prone parts of Northern Ethiopia and elicit from poor, vulnerable farmers their hypothetical willingness to pay using individual and group lottery games. Analyzing the certainty equivalent ratios (CERs), we find that farmer groups are more risk averse than individual farmers. When the risk of the lottery is high, the group CER is primarily determined by the most-risk-averse farmer of the group, and to a lesser extent, by the least. The median farmer contributes to the group CER only when the lottery risk is moderate. After participating in the group elicitation, individual farmers also become as risk averse as the group on average. Specifically, the median and the least-risk-averse farmers become significantly more risk averse while the most-risk-averse farmer is unaffected. Our results show that policymakers should carefully consider how social interactions in rural communities affect individual and group risk preference and whether social interactions also affect the participation and effectiveness of development programs.     

Monetary policy with uncertain central bank preferences

This paper considers monetary policy when policy makers’ preferences are private information. I show that in the first period of a two-period term, all policy makers but the least inflation averse inflate less - but respond more to shocks - than if there were no private information. Moderately inflation-averse policy makers may reduce their inflation most. A tendency toward increased conservatism in their second period increases inflation in the first. With T<∞ period terms, inflation depends solely on the policy maker's time left in office. With unchanging preferences and no discounting, inflation is lower the longer he has left.     

Welfare Effects of Transparency in Foreign Exchange Markets: the Role of Hedging Opportunities

The paper studies the impact of more transparency on the risk‐sharing opportunities in the foreign exchange market and the associated implications on ex ante welfare. Transparency is measured in this model by the informational content of publicly observable signals about exchange rate developments. The authors find that in this model more transparency improves welfare in economies that are poorly endowed with capital and/or where investors are not very risk‐averse, while welfare is reduced in economies with large capital endowments and/or where investors are highly risk‐averse.     

Will Self‐Managed Superannuation Fund Investors Survive?

The relative risk aversion coefficient that characterises the representative self‐managed superannuation fund (SMSF) investor reveals not only how much that investor dislikes risk but also other information about the investor's economic characteristics, including how his or her allocations to risky assets change as his or her wealth changes. Determination of the relative risk aversion coefficient for the average SMSF investor reveals a value of 5.05. This value is too high to be consistent with logarithmic utility. This is significant because it implies that SMSF investors may be too risk averse to maximise the expected growth rate of wealth share accumulation. We are left to consider a very important question: Will SMSF investors survive?     

Risk preference,immigration policy and illegal immigration

The paper analyzes the effects of government policy upon illegal immigration. The model used as a vehicle for this analysis is an extension of Ethier's one-small-country model of illegal immigration to a two-country context. We distinguish between the cases of capital immobility and free capital mobility, and consider illegal immigration when there are border patrols by the government and when there are internal enforcement procedures in effect. Unlike previous researchers who have assumed risk neutrality, we examine the impacts of government policy when prospective illegal immigrants exhibit risk averse and risk loving behavior. The relaxation of the risk neutrality assumption leads to the possibility of multiple and unstable equilibria. Moreover, attitudes to risk and the probability of detection are shown to have implications for some equilibrium responses to tighter surveillance.     

Risk preference,immigration policy and illegal immigration

The paper analyzes the effects of government policy upon illegal immigration. The model used as a vehicle for this analysis is an extension of Ethier's one-small-country model of illegal immigration to a two-country context. We distinguish between the cases of capital immobility and free capital mobility, and consider illegal immigration when there are border patrols by the government and when there are internal enforcement procedures in effect. Unlike previous researchers who have assumed risk neutrality, we examine the impacts of government policy when prospective illegal immigrants exhibit risk averse and risk loving behavior. The relaxation of the risk neutrality assumption leads to the possibility of multiple and unstable equilibria. Moreover, attitudes to risk and the probability of detection are shown to have implications for some equilibrium responses to tighter surveillance.     

RISK AVERSION AND FIELD OF STUDY CHOICE: THE ROLE OF INDIVIDUAL ABILITY

Does the choice of field of study depend on individual risk aversion? The direction of the relationship between individual risk attitudes and type of university degree chosen is potentially ambiguous. On the one hand, risk averse individuals may prefer degree courses which allow high returns in the labour market; on the other hand, if these degrees expose students to a higher probability of dropping out, those who are more risk averse may be induced to choose less challenging fields. Using data from a sample of students enrolled at a middle‐sized Italian public university in 2009, we find that, controlling for a large number of individual characteristics, more risk averse students are more likely to choose any other field (Humanities, Engineering, and Sciences) rather than Social Sciences. We interpret this result bearing in mind that some of these fields, such as Humanities, involve a reduction in the risk of dropping out, while others (such as Engineering and Sciences) involve a lower risk in the labour market. It also emerges that the effect of risk aversion on degree choice is related to student ability. Risk averse students characterized by high abilities tend to prefer Engineering, while the propensity of risk averse students to enrol in Humanities decreases when ability increases, suggesting that the attention paid to labour market risks and drop‐out risk varies according to student skills.     

Parimutuel contests with strategic risk-sensitive bettors

Existing models in the parimutuel betting literature typically explain betting data by either assuming a single, representative bettor with certain risk preferences or by assuming that a number of risk neutral bettors compete strategically within a game theoretic framework. We construct a theoretical framework of parimutuel markets in which we model both strategic interaction and individual bettor risk preferences, distinguishing between sophisticated insiders and recreational outsiders. We solve this model analytically for the optimal insider betting amount in a static symmetric Nash equilibrium. A new data set of 126 million individual horse race bets in New Zealand from 2006 to 2014 allows us to calibrate the model. We find that insiders (those betting $100 or more) outperform outsiders by 7.5% in terms of realized returns. The best fit of the model to the data is obtained when insiders are assumed to be risk neutral and to have an information advantage of 0.08 in probability terms. This finding provides empirical support for the common assumption of risk neutrality in strategic interaction models of parimutuel betting.     

The Determinants of Risk Aversion: The Role of Intergenerational Transmission

This article studies the relationship between risk attitudes and individual characteristics focusing on the intergenerational transmission of risk preferences. We use a dataset of a sample of Italian students which allows us to build different measures of risk aversion based, respectively, on a survey asking students about their willingness to invest in a risky asset and about their preferences for job security and on the results of an entry test using explicit penalty points in the case of incorrect answers. In line with the findings highlighted by the existing literature, we find that women are more risk averse than men, more patient subjects are more risk averse, while high‐ability students are less risk averse. As far as intergenerational transmission of preferences is concerned, it emerges that students whose fathers are entrepreneurs have a higher propensity to take risks, while students whose fathers are employed in the public sector are more risk averse. Only fathers matter with regards to their children's risk attitudes. These results are robust to different measures of risk aversion and to different specifications of our model.     

Monotone risk aversion

Summary. This paper defines decreasing absolute risk aversion in purely behavioral terms without any assumption of differentiability and shows that a strictly increasing and risk averse utility function with decreasing absolute risk aversion is necessarily differentiable with an absolutely continuous derivative. A risk averse utility function has decreasing absolute risk aversion if and only if it has a decreasing absolute risk aversion density, and if and only if the cumulative absolute risk aversion function is increasing and concave. This leads to a characterization of all such utility functions. Analogues of these results also hold for increasing absolute and for increasing and decreasing relative risk aversion.Received: 31 January 2003, Revised: 15 January 2004, JEL Classification Numbers: D81.The views, thoughts and opinions expressed in this paper are those of the author in his individual capacity and should not in any way be attributed to Morgan Stanley or to Lars Tyge Nielsen as a representative, officer, or employee of Morgan Stanley.     

Employment Protection and Unemployment Benefits: On Technology Adoption and Job Creation in a Matching Model

We analyse the effects of different labour‐market policies (employment protection, unemployment benefits, and payroll taxes) on job creation and technology choices in a model where firms are matched with workers of different productivity and wages are determined by ex post bargaining. The model is characterized by two intertwined sources of inefficiency, namely a matching externality and a hold‐up externality associated with the bargaining strength of workers. The results depend on the relative importance of the two externalities and on worker risk aversion. “Flexicurity”, meaning low employment protection and generous unemployment insurance, can be optimal if workers are sufficiently risk‐averse and the hold‐up problem is relatively important.     

Estimating Risk Attitudes in Denmark: A Field Experiment*

We estimate individual risk attitudes using controlled experiments in the field in Denmark. The experiments were carried out across Denmark using a representative sample of 253 people between 19 and 75 years of age. Risk attitudes are estimated for various individuals differentiated by socio‐demographic characteristics. Our results indicate that the average Dane is risk averse, and that risk neutrality is an inappropriate assumption to apply. We also find that risk attitudes vary significantly with respect to several important socio‐demographic variables such as age and education. However, we do not find any effect of sex on risk attitudes.     

Endogenous entry and self-selection in private value auctions: An experimental study

This paper presents the results of an experimental study of endogenous entry in first-price independent private value auctions. N potential bidders simultaneously decide whether to participate in an auction or receive a known outside option. In the second stage, entrants submit bids after learning their own private values and the number of entrants. An equilibrium model of heterogeneous risk averse bidders implies a self-selection effect, where bidding in the auction is lower with endogenous entry because only less risk averse bidders enter. This effect is confirmed by the experiment. We also observe excessive entry relative to the theoretical model.     

Optimal sequential contract with a risk‐averse supplier

We study optimal contracts in environments where a risk‐averse supplier discovers cost information privately and gradually over time: the supplier is privately informed about its cost uncertainty at the time of contracting and discovers the realization of cost condition privately after contracting and before production. We show that both the buyer and the supplier prefer more cost uncertainty when the supplier is not very risk‐averse but less cost uncertainty when the supplier is sufficiently risk‐averse. However, the buyer always prefers to contract before the cost uncertainty resolves regardless of the supplier's degree of risk aversion. The nature of the optimal contract also depends on the supplier's risk preference. A separating contract is optimal when the supplier is not very risk‐averse; however, a pooling contract, which offers the same contract terms regardless of the cost uncertainty, can be optimal when the supplier becomes sufficiently risk‐averse. Moreover, the optimal production schedule is often characterized by “inflexible rules.”     

Fiscal Decentralization and Political Budget Cycles

We analyze a problem à la Rogoff where incumbents can distort fiscal policy to signal their competency, but where fiscal policy can be centralized or decentralized. Our main focus is on how the equilibrium probability that fiscal policy is distorted in any region (the political budget cycle, PBC) differs across fiscal regimes. With centralization, there are generally two effects that change the probability of a PBC. One is the possibility of selective distortion: the incumbent can be reelected with the support of just a majority of regions. The other is a cost diversification effect, which is present unless costs are perfectly correlated across regions. Both these effects work in the same direction, with the general result that the PBC probability is lower under centralization when decentralization also involves PBC. Welfare analysis shows that voters tend to be better off when the PBC probability is lower, so voters prefer centralization when decentralization involves PBC. Our results are robust to a number of changes in the specification of the model.     

Risk aversion and incentive compatibility with ex post information asymmetry

Summary. The paper extends Diamond's (1984) analysis of financial contracting with information asymmetry ex post and endogenous “bankruptcy penalties” to allow for risk aversion of the borrower. The optimality of debt contracts, which Diamond obtained for the case of risk neutrality, is shown to be nonrobust to the introduction of risk aversion. This contrasts with the costly state verification literature, in which debt contracts are optimal for risk averse as well as risk neutral borrowers. Received: December 7, 1998; revised version: June 9, 1999     

k-Price Auctions

In this paper we analyze the equilibria structure of k-price auctions, k ≥ 3, under the independent-private-value assumption. We discuss agents with an arbitrary attitude toward risk. That is, agents may be risk averse or risk seeking, or they may have an alternating attitude toward risk. We provide a characterization of a continuous symmetric equilibrium, prove that there exists at most one such equilibrium, and show that every such equilibrium is differentiable and increasing. We also show some additional general properties of the equilibrium strategies in these auctions. Journal of Economic Literature Classification Numbers: C72, C73, D83.