Prospect Theory and Mean-Variance Analysis

The experimental results of prospect theory (PT) reveal suggestthat investors make decisions based on change of wealth ratherthan total wealth, that preferences are S-shaped with a risk-seekingsegment, and that probabilities are subjectively distorted.This article shows that while PT's findings are in sharp contradictionto the foundations of mean-variance (MV) analysis, counterintuitively,when diversification between assets is allowed, the MV and PT-efficientsets almost coincide. Thus one can employ the MV optimizationalgorithm to construct PT-efficient portfolios.     

Overcoming free riding in multi-party computations—The anonymous case

This paper addresses the question of multi-party computation in a model with asymmetric information. Each agent has a private value (secret), but in contrast to standard models, the agent incurs a cost when retrieving the secret. There is a social choice function the agents would like to compute and implement. All agents would like to perform a joint computation, which input is their vector of secrets. However, agents would like to free-ride on others' contribution.A mechanism which elicits players' secrets and performs the desired computation defines a game. A mechanism is ‘appropriate’ if it (weakly) implements the social choice function for all secret vectors. namely, if there exists an equilibrium in which it is able to elicit (sufficiently many) agents' secrets and perform the computation, for all possible secret vectors. We show that ‘appropriate’ mechanisms approach agents sequentially and that they have low communication complexity.     

Are rich people smarter?

We formulate a general stochastic process of wealth accumulation by capital investment and analyze the conditions required to ensure convergence to the empirically observed Pareto wealth distribution. While homogeneous investment talent leads to the Pareto distribution under very general conditions, even a mild degree of differential investment talent results in a non-Pareto wealth distribution. This finding suggests that chance, rather than differential investment talent, is the dominant factor in the process of wealth accumulation by financial investment. Our findings conform with market efficiency and may have implications regarding the origins, the economic significance, and the social desirability of wealth inequality at the high-wealth range.     

Book Review

Book review
Phelim Boyle and Feidh Lim Boyle, Derivatives: The Tools that Changed Finance     

Hybrid Choice Models: Progress and Challenges

We discuss the development of predictive choice models that go beyond the random utility model in its narrowest formulation. Such approaches incorporate several elements of cognitive process that have been identified as important to the choice process, including strong dependence on history and context, perception formation, and latent constraints. A flexible and practical hybrid choice model is presented that integrates many types of discrete choice modeling methods, draws on different types of data, and allows for flexible disturbances and explicit modeling of latent psychological explanatory variables, heterogeneity, and latent segmentation. Both progress and challenges related to the development of the hybrid choice model are presented.     

Place-to-place migration in Israel: estimates of a logistic model

"A multinomial logit model focusing on economic and other locational factors is formulated and applied to data on place-to-place migration in Israel. Results indicate the effects of expected industrial wage differentials, in accordance with the hypothesis of Harris and Todaro (1970), and of disparities in the structure of industrial employment, suggesting that perceived risk as well as expected return enter into the decision to migrate, as Stark and Levhari (1982) have argued. Other effects include those associated with regional differentials in amenities and agglomeration associated with urbanization, population mobility by age group, center-periphery migration trends, border security hazards, and the like. Implications of the analysis for the Israeli policy of population dispersion are discussed."     

Forum Selection in International Business Contracts: Home Bias Portfolio Puzzle and Managerial Moral Hazard

We provide an economic analysis of forum selection in international business contracts. International business contracts or multi-state transactions within federally structured countries might be subject to more than one sovereign adjudication system. In case of conflict between the transacting parties, the appropriate tribunal must be identified. We examine the question of business firms' optimal choice of the forums to adjudicate future business disputes. We extend the investment model approach to litigation by applying a portfolio theory type analysis. We show that firms that prefer higher expected income and lower income volatility are better off diversifying the forums under which they litigate business disputes. This stands in contrast to real-world business practice that consistently shows a clear preference to selecting the home court and legal system to settle international business disputes. In a fraction of the cases, both parties gain by selecting a certain forum, because of specialization for example, and it becomes optimal to ignore diversification. In most cases, however, the relevant factors that affect forum selection are zero sum and priced ex ante, court bias, for example. Once priced, there is no incentive to disregard diversification. We hypothesize that, in addition to specialization, factors such as managerial moral hazard explain the real-world behavior of firms: managers are less likely to be blamed, ex post, for choosing the home court. We suggest that, as international barriers decline and international trade grows, firms will diversify the forums in which they adjudicate international business disputes.     

How accurate is the integrated vendor–buyer continuous model?

The classic single-item, deterministic-demand, integrated vendor–buyer model is revisited. The decision problem may also be viewed as that of one centralized firm, dealing with a two-level EOQ-like supply chain with finite production rates. It is sought to optimize the production lot-size and the integral number of its shipments, in equal batches, from the vendor to the buyer. While the problem calls for discrete optimization techniques, we introduced a continuous model where one can take derivatives with respect to both variables. In this short paper, we establish a 98.5% lower bound on the accuracy of this continuous model.