Saving under rank-dependent utility

Summary. In this note we use the rank-dependent utility (RDU) model to analyze saving decisions. The RDU model enables us to separate the effects of pessimism and optimism on saving from that of concavity of the utility function. While pessimism induces more saving, the importance of this effect is shown to depend upon properties of the utility function such as prudence and temperance.JEL Classification Numbers: D11, D81.An anonymous referee provided helpful comments. Han Bleichrodts research was made possible by a grant from the Netherlands Organisation for Scientific Research (NWO). Louis Eeckhoudt acknowledges support from the Interuniversity Attraction Poles Programme - Belgian State - Federal Office for Scientific, Technical, and Cultural Affairs.     

More pessimism than greediness: a characterization of monotone risk aversion in the rank-dependent expected utility model

Summary. This paper studies monotone risk aversion, the aversion to monotone, mean-preserving increase in risk (Quiggin [21]), in the Rank Dependent Expected Utility (RDEU) model. This model replaces expected utility by another functional, characterized by two functions, a utility function u in conjunction with a probability-perception function f. Monotone mean-preserving increases in risk are closely related to the notion of comparative dispersion introduced by Bickel and Lehmann [3,4] in Non-parametric Statistics. We present a characterization of the pairs (u,f) of monotone risk averse decision makers, based on an index of greediness G _u of the utility function u and an index of pessimism P _f of the probability perception function f: the decision maker is monotone risk averse if and only if . The index of greediness (non-concavity) of u is the supremum of taken over . The index of pessimism of f is the infimum of taken over 0 < v < 1. Thus, , with G _u = 1 iff u is concave. If then , i.e., f is majorized by the identity function. Since P _f = 1 for Expected Utility maximizers, forces u to be concave in this case; thus, the characterization of risk aversion as is a direct generalization from EU to RDEU. A novel element is that concavity of u is not necessary. In fact, u must be concave only if P _f = 1.Received: 10 April 2001, Revised: 18 November 2003, JEL Classification Numbers: D81. Correspondence to: Michéle CohenAlain Chateauneuf, Michéle Cohen, Isaac Meilijson: We are most grateful to Mark Machina, Peter Wakker and two anonymous referees for very helpful suggestions and comments.     

A simple axiomatization and constructive representation proof for choquet expected utility

>P>Summary. We provide a set of simple and intuitive set of axioms that allow for a direct and constructive proof of the Choquet Expected Utility representation for decision making under uncertainty. Received: October 29, 2002; revised version: November 13, 2002 RID="*" ID="*" We thank Matthew Ryan for very useful comments and suggestions on related work and for encouraging us to write this note. Correspondence to: S. Grant     

Option price without expected utility

We consider the meaning of the option price, commonly acknowledged as the preferred ex ante welfare measure, in the rank-dependent expected utility (RDEU) framework. The importance of this pertains to performing benefit-cost analysis when RDEU maximizers are prevalent in society.     

The impossibility of compromise: some uniqueness properties of expected utility preferences

Summary. We focus on the following uniqueness property of expected utility preferences: Agreement of two preferences on one interior indifference class implies their equality. We show that, besides expected utility preferences under (objective) risk, this uniqueness property holds for subjective expected utility preferences in Anscombe-Aumann's (partially subjective) and Savage's (fully subjective) settings, while it does not hold for subjective expected utility preferences in settings without rich state spaces. Indeed, when it holds the uniqueness property is even stronger than described above, as it needs only agreement on binary acts. The extension of the uniqueness property to the subjective case is possible because beliefs in the mentioned settings are shown to satisfy an analogous property: If two decision makers agree on a likelihood indifference class, they must have identical beliefs. Received: November 15, 1999; revised version: December 29, 1999     

Background risk in generalized expected utility theory

Summary. In this paper, it is shown that, for a wide range of risk-averse generalized expected utility preferences, independent risks are complementary, contrary to the results for expected utility preferences satisfying conditions such as proper and standard risk aversion. Received: August 10, 2001; revised version: June 18, 2002 RID="*" ID="*"I thank Simon Grant and an anonymous referee for helpful comments and criticism. This research was supported by an Australian Research Council Senior Fellowship and Australian Research Council Large Grant A79800678.     

Subjective ambiguity, expected utility and Choquet expected utility

Summary. Using the Savage set up, this paper provides a simple axiomatization of the Choquet Expected Utility model where the capacity is an inner measure. Two attractive features of the model are its specificity and the transparency of its axioms. The key axiom states that the decision-maker uses unambiguous acts to approximate ambiguous ones. In addition, the notion of ‘ambiguity’ is subjective and derived from preferences. Received: March 23, 2000; revised version: April 24, 2001     

Diversification, convex preferences and non-empty core in the Choquet expected utility model

Summary. We show, in the Choquet expected utility model, that preference for diversification, that is, convex preferences, is equivalent to a concave utility index and a convex capacity. We then introduce a weaker notion of diversification, namely “sure diversification.” We show that this implies that the core of the capacity is non-empty. The converse holds under concavity of the utility index, which is itself equivalent to the notion of comonotone diversification, that we introduce. In an Anscombe-Aumann setting, preference for diversification is equivalent to convexity of the capacity and preference for sure diversification is equivalent to non-empty core. In the expected utility model, all these notions of diversification are equivalent and are represented by the concavity of the utility index. Received: July 27, 1999; revised version: November 7, 2000     

Corporate insurance with optimal financial contracting

Summary. This paper attemps to rationalize the use of insurance covenants in financial contracts, and shows how external financing generates a demand for insurance by risk-neutral entrepreneurs. In our model, the entrepreneur needs external financing for a risky project that can be affected by an accident during its realization. Accident losses and final returns are private information to the firm, but they can be evaluated by two costly auditing technologies. We derive the optimal financial contract: it is a bundle of a standard debt contract and an insurance contract with franchise, trading off bankruptcy costs vs auditing costs. We then analyze how this optimal contract can be achieved by decentralized trading on competitive markets when insurance and credit activities are exogenously separated. With additive risks, the insurance contract involves full coverage above a straight deductible. We interpret this result by showing how our results imply induced risk aversion for risk-neutral firms. Received: December 14, 1998; revised version: August 11, 1999     

Endogenous technological change with leisure-dependent utility

Summary. This paper investigates the effect of introducing leisure-dependent utility into two models of endogenous technological change. Due to the flexibility in the labour supply the dynamics of the models change significantly. It is shown that if agents attach enough value to leisure in comparison to consumption two balanced growth paths may exist. This implies that economies with the same preferences and the same technology may experience different long-run growth rates. Received: October 17, 1997; revised version: January 6, 1999     

Upper and lower bounds for expected utility

Summary.   The decision-theoretic literature has developed very few techniques to bound the expected utility of a random variable when only simple statistics like its median or mode or mean are known. One reason for this lack of results is that we are missing a convenient way to link probability theory and expected utility. This paper is written to demonstrate a general (and genuinely probabilistic) technique to obtain upper and lower bounds for the expected utility of a lottery. Received: December 14, 1999; revised version: March 8, 2000     

Differentiable von Neumann-Morgenstern utility

Summary. Differentiability is a convenient property of von Neumann-Morgenstern utility functions which is almost always imposed but has not been translated into behavioral terms. In applications, expected utility is usually maximized subject to a constraint, and the maximization is carried out by differentiating the utility function. This paper presents two sets of necessary and sufficient conditions for a risk averse von Neumann-Morgenstern utility function to be differentiable. The first of them is formulated in terms of the equivalent risk premia of small gambles. It says, in brief, that the equivalent risk premium is of a smaller order of magnitude than the risk itself, as measured by the expectation of the absolute value of the risk. The second set of necessary and sufficient conditions is formulated in terms of the probability premium of small lotteries. It says, essentially, that the probability premium for small binary lotteries goes to zero as the size of the lottery goes to zero. Received: May 11, 1997; revised version: May 14, 1998     

Pareto efficient insurance contracts when the insurer's cost function is discontinuous

Summary. We consider the problem of efficient insurance contracts when the cost structure includes a fixed cost per claim. We prove existence of efficient insurance contracts and that the indemnity function in such contracts is non-decreasing in the damage. We further show that either there is no insurance, or the indemnity is positive for all losses, or efficient insurance contracts have a unique jump. We study variants of the model and provide a generalization to the case of non expected utilities. Our results are then applied to Townsend's model of deterministic auditing. Received: November 8, 2000; revised version: March 12, 2002 RID="*" ID="*" We are grateful to F. Salanié for pointing out an error in the previous version of the paper and for suggesting Proposition 6 to us. Correspondence to: R.-A. Dana     

Range convexity and ambiguity averse preferences

We show that range convexity of beliefs, a `technical' condition that appears naturally in axiomatizations of preferences in a Savage-like framework, imposes some unexpected restrictions when modelling ambiguity averse preferences. That is, when it is added to a mild condition, range convexity makes the preferences collapse to subjective expected utility as soon as they satisfy structural conditions that are typically used to characterize ambiguity aversion. Received: February 25, 2000; revised version: April 17, 2000     

Revisiting Savage in a conditional world

Summary. I present an axiomatization of subjective expected utility and Bayesian updating in a conditional decision problem. This result improves our understanding of the Bayesian standard from two perspectives: 1) it uses a set of axioms which are weak and intuitive; 2) it provides a formal proof to results on the relation between dynamic consistency, expected utility and Bayesian updating which have never been explicitly proved in a fully subjective framework. Received: December 1, 2000; revised version: February 26, 2001     

Uncertainty and insurance in strategic market games

Summary. For perfectly competitive economies under uncertainty, there is a well-known equivalence between a formulation with contingent goods and one with state-specific securities followed by spot markets for goods. In this paper, I examine whether this equivalence carries over to a particular form of imperfect competition. Specifically, I look at three Shapley-Shubik strategic market games: one with contingent commodities, one with Arrow securities traded under imperfect competition and one with Arrow securities traded under perfect competition. First I compare the feasibility constraints of these three games. Then I compare their equilibrium sets. As in Peck and Shell (1989), the only common equilibria between the first and the second game are those which involve no transfer of income across states. However, if the securities markets are competitive, then the set of equilibria of the contingent commodities game and the securities game coincide. Received: June 16, 1997; revised version: April 30, 1998     

A general model of insurance under adverse selection

Summary. This paper considers optimal insurance schemes in a principal-agent multi-dimensional environment in which two types of risk averse agents differ in both risk and attitude to risk. Risk corresponds to any pair of distribution functions (not necessarily ordered by any of the usual dominance relations) and attitudes to risk are represented by any pair of non-decreasing and concave utility functions (not necessarily ordered by risk aversion). Results obtained in one-dimensional models that considered these effects separately and under more restricted conditions, are preserved in the more general set-up, but some of the questions we study can only be posed in the more general framework. The main results obtained for optimal insurance schemes are: (i) Insurance schemes preserve the order of certainty equivalents; consequently, the latter constitute a one-dimensional representation of types. (ii) Agents with the lower certainty equivalent are assigned full insurance. Partial insurance assigned to the others may entail randomization. (iii) Partially insured positions are an increasing function of the ratios of the probabilities that the two types assign to the uninsured positions. Most of these properties are preserved when, due to competition or other reasons, the insured certainty equivalents can not be set below pre-determined levels. Received: January 13, 1998; revised version: October 10, 1998     

Money, banks and endogenous volatility

Summary. In this paper I consider a monetary growth model in which banks provide liquidity, and the government fixes a constant rate of money creation. There are two underlying assets in the economy, money and capital. Money is dominated in rate of return. In contrast to other papers with a larger set of government liabilities, I find a unique equilibrium when agents' risk aversion is moderate. However, indeterminacies and endogenous volatility can be observed when agents are relatively risk averse. Received: March 11, 1999; revised version: March 30, 1999     

The set of sunspot equilibria in economies with incomplete financial markets: variable asset prices

Summary. I consider the set of equilibria of two-period economies with S extrinsic states of nature in the second period and I assets with linearly independent nominal payoffs. Asset prices are variable. If the number of agents is greater than (S-I), the payoff matrix is in general position and S 2I, the set of equilibrium allocations generically (in utility function space) contains a smooth manifold of dimension (S-1). Moreover, the map from states o f nature to equilibrium allocations (restricted to this manifold) is one-to-one at each equilibrium. Received: February 23, 1998; revised version: June 1, 2000