On-demand or Spot? Selling the cloud to risk-averse customers

In Amazon EC2, cloud resources are sold through a combination of an on-demand market, in which customers buy resources at a fixed price, and a spot market, in which customers bid for an uncertain supply of excess resources. Standard market environments suggest that an optimal design uses just one type of market. We show the prevalence of a dual market system can be explained by heterogeneous risk attitudes of customers. In our stylized model, we consider unit demand risk-averse bidders. We show the model admits a unique equilibrium, with higher revenue and higher welfare than using only spot markets. Furthermore, as risk aversion increases, the usage of the on-demand market increases. We conclude that risk attitudes are an important factor in cloud resource allocation and should be incorporated into models of cloud markets.Comment: Appeared at WINE 201

Economics and psychology.Perfect rationality versus bounded rationality

Classical mathematical algorithms often fail to identify in time when the international financial crises occur although, as the classical theory of choice would suggest, the economic agents are rational and the markets are or should be efficient and behave also rationally. This contribution does not pretend to give a complete answer to these questions, but it will highlight some well-known limits of the classical theory of rational choice and compare this theory of choice with the approach that seeks to combine economics and psychology and that has established itself as cognitive or behavioral economics. In particular, the present paper will focus on the juxtaposition of the concepts of perfect rationality and bounded rationality. It concludes with some references to the literature of behavioral finance which has given important contributions in explaining the behavior and the anomalies of financial markets.Bounded rationality; procedural rationality; rational choice; cognitive economics

On the Scientific Status of Economic Policy: A Tale of Alternative Paradigms

In the last years, a number of contributions has argued that monetary -- and, more generally, economic -- policy is finally becoming more of a science. According to these authors, policy rules implemented by central banks are nowadays well supported by a theoretical framework (the New Neoclassical Synthesis) upon which a general consensus has emerged in the economic profession. In other words, scientific discussion on economic policy seems to be ultimately confined to either fine-tuning this "consensus" model, or assessing the extent to which "elements of art" still exist in the conduct of monetary policy. In this paper, we present a substantially opposite view, rooted in a critical discussion of the theoretical, empirical and political-economy pitfalls of the neoclassical approach to policy analysis. Our discussion indicates that we are still far from building a science of economic policy. We suggest that a more fruitful research avenue to pursue is to explore alternative theoretical paradigms, which can escape the strong theoretical requirements of neoclassical models (e.g., equilibrium, rationality, etc.). We briefly introduce one of the most successful alternative research projects -- known in the literature as agent-based computational economics (ACE) -- and we present the way it has been applied to policy analysis issues. We conclude by discussing the methodological status of ACE, as well as the (many) problems it raises.Economic Policy, Monetary Policy, New Neoclassical Synthesis, New Keynesian Models, DSGE Models, Agent-Based Computational Economics, Agent-Based Models, Post-Walrasian Macroeconomics, Evolutionary Economics.

RISK, GOVERNMENT PROGRAMS, AND THE ENVIRONMENT

Nearly all farm business ventures involve financial risk. In some instances, private and public tools used to manage financial risks in agriculture may influence farmers' production decisions. These decisions, in turn, can influence environmental quality. This bulletin summarizes research and provides some perspective on private and public attempts to cope with financial risks and their unintended environmental consequences. Specifically, it examines the conceptual underpinnings of risk-related research, challenges involved with measuring the consequences of risk for agricultural production decisions, government programs that influence the risk and return of farm businesses, and how production decisions influence both the environment and the risk and average returns to farming.risk, agricultural production, government programs, environment, Agricultural and Food Policy, Environmental Economics and Policy, Risk and Uncertainty,

Anomalies in Economics and Finance

The term “anomaly” played a crucial role in Thomas Kuhn’s characterization of scientific progress. For Kuhn, an anomaly is a puzzle which challenges an accepted paradigm. Puzzles only achieve anomalous status once an alternative paradigm becomes available which allows explanation of the puzzle. Anomalies were introduced into the finance literature by Michael Jensen but more as resolvable puzzles than Kuhnian anomalies. They entered economics via Richard Thaler who saw behavioural economics as the alternative to the neoclassical paradigm. Both authors use the term anomaly in a deliberately Kuhnian manner. Kuhn formulated his ideas by looking back across the history of physics. By contrast, behavioural economists use Kuhn’s concepts in a forward-looking manner as a marketing tool for their ideas.anomaly, behavioural, effects.

Risk taking in financial markets : a behavioral perspective

Since the innovative work of Kahneman and Tversky (1979), behavioral finance has become one of the most active areas in financial economics. As compared to traditional models in this area, behavioral models often have the degree of flexibility that permits reinterpretation to fit new facts. Unfortunately, this flexibility makes it hard either to disprove or to validate behavioral models. In the present thesis we try to overcome this problem, by proposing a general framework based on stylized facts of human behavior (invariants); and applying it to three financial contexts. Related to the individual risk taking decision, we focus: on the role of incentives; on how prior outcomes influence future decision; and on the portfolio choice problem. Different from traditional models where risk aversion is usually assumed, in our behavioral framework, the risk preference of the investor varies depending on how he frames his choices. Our main conclusion is that absolute evaluations based on final wealth are limited and the relativity of risk taking decisions, where the perception of gains and losses drives the process, is a requirement to understand individual’s decisions. As a reply to behavioral critics, we reach propositions that can be falsified and make several predictions. Summing up, under the same theoretical framework we make the following contributions: (1) Shed more light on how incentives affect risk taking behavior, proposing a model where the reference plays a central role in the previous relationship; (2) Empirically test our incentives model considering a comprehensive world sample of equity funds (cross-section data); (3) Evaluate which effect is stronger in multi-period risk taking decisions for individual investors: house-money or disposition effect, proposing a novel experiment treatment; (4) Compare survey to experimental results finding that they are not necessarily aligned. (5) Generalize the myopic loss aversion behavior performing an experiment in Brazil and Spain; (6) Propose a theoretical model of how behavioral individuals choose their portfolios in terms of risk taking behavior; (7) Include estimation error in the behavioral portfolio analysis; (8) Evaluate whether theoretical models of portfolio choice should adapt or moderate the individual behavior characteristics. In this case we used a sample of several country equity indices. Our propositions suggest that managers in passive managed funds tend to be rewarded without incentive fee and be risk averse. On the other hand, in active managed funds, whether incentives will reduce or increase the riskiness of the fund will depend on how hard it is to outperform the benchmark. If the fund is (un)likely to outperform the benchmark, incentives (increase) reduce the manager’s risk appetite. Furthermore, the evaluative horizon influences the trader’s risk preferences, in the sense that if traders performed poorly (well) in a period, they tend to choose riskier (conservative) investments in the following period given the same evaluative horizon. Empirical evidence, based on a comprehensive world sample of mutual funds is also presented in this chapter and gives support to the previous propositions. Related to the house-money and disposition effect, we employ a survey approach and find evidence of house money effect. However, in an experiment performed in a dynamic financial setting, we show that the house money effect disappears, and that disposition is the dominant effect. We report supportive results related to existence of myopic loss aversion across countries and some evidence of country effect. Finally, in terms of asset allocation, our results support the use of our behavioral model (BRATE) as an alternative for defining optimal asset allocation and posit that a portfolio optimization model may be adapted to the individual biases implied by prospect theory without efficiency loss. We also explain why investors keep on holding, or even buy, loosing investments. ______________________________________________________________________________________________________________________________________________________Desde el trabajo innovador de Kahneman y de Tversky (1979), las finanzas del comportamiento se han convertido en una de las áreas más activas en la economía financiera. Comparados con los modelos tradicionales en esta área, los modelos del comportamiento tienen a menudo el grado de flexibilidad que permite su reinterpretación, ajustándoles a nuevos hechos empíricos. Desafortunadamente, esta flexibilidad hace difícil refutar o validar modelos del comportamiento. En la actual tesis intentamos superar este problema, proponiendo un marco general basado en hechos estilizados del comportamiento humano (invariables); y aplicándolo a tres contextos financieros. Relacionado con la decisión individual de toma de riesgo, nos enfocamos: en el papel de los incentivos financieros; en cómo los resultados anteriores influencian la decisión futura; y en el problema de la gerencia de cartera. Diferente de los modelos tradicionales donde la aversión al riesgo se asume generalmente, en nuestro marco del comportamiento, la preferencia del riesgo del inversionista varía dependiendo de cómo él enmarca sus opciones. Nuestra conclusión principal es que las evaluaciones absolutas basadas en la riqueza final son limitadas y la relatividad de las decisiones de riesgo, donde la percepción de las ganancias y de las pérdidas conduce el proceso, son un requisito para entender las decisiones del individuo. Como contestación a los críticos del comportamiento, alcanzamos proposiciones que pueden ser contrastadas y hacemos varias predicciones. Resumiendo, bajo el mismo marco teórico hacemos las contribuciones siguientes: (1) Verificamos cómo los incentivos afectan el comportamiento de toma de riesgo, proponiendo un modelo donde la referencia desempeña un papel central en la relación anterior; (2) Empíricamente contrastamos nuestro modelo de incentivos en vista de una muestra mundial representativa de los fondos de acciones; (3) Evaluamos qué efecto es más fuerte en un estudio dinámico del comportamiento individual de toma de riesgo: house-money o disposition effect, proponiendo un nuevo tratamiento experimental; (4) Comparamos los resultados de una encuesta a los experimentales y verificamos que no están necesariamente alineados. (5) Generalizamos el comportamiento miope de la aversión de la pérdida (myopic loss aversion) con un experimento realizado en Brasil y España; (6) Proponemos un modelo teórico de cómo los individuos sesgados eligen sus carteras en términos de toma de riesgo; (7) Incluimos el error de la estimación en el análisis de la cartera; (8) Evaluamos si los modelos teóricos de la selección de carteras deben adaptarse a las características sesgadas de los individuos o moderar las características individuales del comportamiento. En este caso utilizamos una muestra de varios índices de acciones de diversos países. Nuestras proposiciones sugieren que los gerentes en fondos manejados pasivamente tiendan a ser recompensados sin el honorario variable y sean adversos al riesgo. Por otra parte, en fondos manejados activamente, si los incentivos reducirán o aumentarán la toma de riesgo del fondo dependerá de su posibilidad de superar la rentabilidad de su cartera de referencia. Si es probable que el fondo supere la cartera de referencia, los incentivos (aumentan) reducen el apetito del riesgo del gerente. Además, el horizonte evaluativo influencia las preferencias del riesgo del gerente, en el sentido que si han obtenido mal (buenos) resultados en un período, ellos tienden para elegir inversiones (conservadoras) más arriesgadas en el período siguiente dado el mismo horizonte evaluativo. La evidencia empírica presentada en la tesis considerando una base representativa de fondos de acciones soporta esas predicciones. Relacionado con el house money y disposition effect, empleamos una encuesta y verificamos la existencia de house money. Sin embargo, en un experimento demostramos que desaparece el efecto house money, y que disposition es el efecto dominante. Nuestros resultados también soportan la existencia de la aversión miope de la pérdida a través de países y una cierta evidencia del efecto del país. Finalmente, en términos de gerencia de carteras, nuestros resultados apoyan el uso de nuestro modelo del comportamiento (BRATE) como alternativa para definir la asignación óptima de los activos y postulamos que un modelo optimización de cartera se puede adaptar a los sesgos individuales implicados por la teoría (prospect theory) sin pérdida de la eficacia

Affective Decision Making: A Behavioral Theory of Choice

Affective decision-making is a strategic model of choice under risk and uncertainty where we posit two cognitive processes — the "rational" and the "emotional" process. Observed choice is the result of equilibirum in this intrapersonal game. As an example, we present applications of affective decision-making in insurance markets, where the risk perceptions of consumers are endogenous. We then derive the axiomatic foundation of affective decision making, and show that, although beliefs are endogenous, not every pattern of behavior is possible under affective decision making.Affective choice, Endogenous risk perception, Insurance, Variational preferences

Reference-Dependent Preferences

In this chapter, we present theories and applications of reference-dependent preferences. We provide some historical perspective, but also move quickly to the current research frontier, focusing on developments in reference dependence over the last 20 years. We present a number of worked examples to highlight the broad applicability of reference dependence. While our primary focus is gain–loss utility, we also provide a short treatment of probability weighting and its links to reference dependence