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Explaining the anomalies of the exponential discounted utility model

By Ali al-Nowaihi and Sanjit Dhami

Abstract

In a major contribution, Loewenstein and Prelec (1992) (LP) set the founda-\ud tions for the behavioral approach to decision making over time. We show that the\ud LP theory is incompatible with two very useful classes of value functions: the HARA\ud class and the constant loss aversion class. Resultingly, the LP theory has been used\ud infrequently in applications, which have largely used the ; form of hyperbolic pref-\ud erences. We propose a more general but equally tractable class of utility functions,\ud the simple increasing elasticity (SIE) class, which is compatible with constant loss\ud aversion in a reformulated version of LP. Allowing for reference dependence and dif-\ud ferent discount rates for gains and losses the SIE class is able to explain impatience,\ud gain-loss asymmetry, magnitude e¤ect, and the delay-speedup asymmetry even un-\ud der exponential discounting. If combined instead with the (reformulated) LP theory,\ud the SIE class in addition can also explain the common di¤erence e¤ect

Topics: Anomalies of the DU model, Intertemporal choice, Generalized hyper-bolic discounting, loss aversion, HARA utility functions, SIE value functions
Publisher: Dept. of Economics, University of Leicester
Year: 2007
OAI identifier: oai:lra.le.ac.uk:2381/7466

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