Negative recency, randomization device choice, and reduction of compound lotteries

We report an experiment in which subjects are not indifferent between real-money lotteries implemented with randomization devices that are equivalent under the Reduction Axiom. Instead choice behavior is consistent with subjective distortion of conditional probability, and this persists in treatment conditions that control for (i) computational limitations and (ii) possible confounding by ratio bias. --reduction of compound lotteries,negative recency effect,gambler's fallacy,law of small numbers,randomization devices,instruments and materials,design of experiments,St. Petersburg paradox

Alternation Bias and the Parameterization of Cumulative Prospect Theory

Two recently published studies argue that conventional parameterizations of cumulative prospect theory (CPT) fail to resolve the St. Petersburg Paradox. Yet as a descriptive theory CPT is not intended to account for the local representativeness effect, which is known to induce 'alternation bias' on binary iid sequences such as those generated by coin tossing in St. Petersburg gambles. Once alternation bias is controlled for, conventional parameterizations of CPT yield finite certainty equivalents for the St. Petersburg gamble, negating the suggested need for reparameterization. Moreover, the associated willingness to pay estimates fall within the generally accepted empirical range.Chapter

Ensemble Prospectism

Incomplete preferences displaying ‘mildly sweetened’ structure are common, yet theoretically problematic. This paper examines the properties of the rankings induced by the set of all coherent completions of the mildly sweetened partial preference structure. Building on these properties, I propose an ensemble-based refinement of Hare’s (Analysis 70:237–247, 2010) prospectism criterion for rational choice when preferences are incomplete. Importantly, this ensemble-based refinement is immune to Peterson’s (Theory & Decision 78:451–456, 2015) weak money pump argument. Hence, ensemble prospectism ensures outcome rationality. Furthermore, by recognizing the structural isomorphism between mildly sweetened preference structures and Cover’s splitting rule in Blackwell’s Pick the Largest Number problem (Ann Math Stat 22:393–399, 1951), ensemble prospectism can be shown to yield better-than-even odds of selecting the expost higher-utility option – despite the absence of all-things-considered preferences ex ante

Not being smart about Article 50: the strategic considerations of an early 2017 notification

Theresa May has recently announced that negotiations for exiting the EU will begin by March 2017. What this means is that the composition of the Council of Ministers at that time is known – and it does not look likely that it will draw up a negotiating mandate that meets the UK’s main demands: lowering immigration and preserving market access. A late-2017 notification, however, following key elections across the EU, might have been a better alternative, writes Kim Kaivanto

Alternation bias and reduction in St. Petersburg gambles:an experimental investigation

Reduction of compound lotteries is implicit both in the statement of the St. Petersburg Paradox and in its resolution by Expected Utility (EU).We report three real-money choice experiments between truncated compound-form St. Petersburg gambles and their reduced-form equivalents. The first tests for differences in elicited Certainty Equivalents. The second develops the distinction between ‘weak-form’ and ‘strong-form’ rejection of Reduction, as well as a novel experimental task that verifiably implements Vernon Smith’s dominance precept. The third experiment checks for robustness against range and increment manipulation. In all three experiments the null hypothesis of Reduction is rejected, with systematic deprecation of the compound form in favor of the reduced form. This is consistent with the predictions of alternation bias. Together these experiments offer evidence that the Reduction assumption may have limited descriptive validity in modelling St. Petersburg gambles, whether by EU or non-EU theories

When are capital structure decisions nonseparable from production planning?:the case of generalized royalty-based hybrid finance

The well-known result that capital structure is irrelevant for firm value follows from a set of assumptions conducive to theoretical analysis. In this note we explore the implications of relaxing one of these assumptions: the independence of cash flows from capital structure. Unlike debt and equity, funding that is accompanied by a royalty payment obligation has the effect of increasing marginal cost, to which a profit-maximizing firm responds by reducing output, violating the independence assumption. We study the effect on optimal production plans of generalized royalty payment obligations in which the royalty rate need not be constant across partitions of cumulative output, resulting in piece-wise linear cumulative royalty schedules that are not everywhere differentiable. The associated optimization problem for intertemporal production planning is nonstandard as it is not time separable. Here we solve this nonstandard problem by formulating an equivalent problem that in turn can be solved by the Pontryagin Maximum Principle using numerical techniques. When generalized royalty-based finance is included in the financing mix, the optimal production plan is non-trivially related to capital structure and capital structure is relevant to firm value. Unless the financing mix is restricted to debt and equity, financing decisions and production planning decisions cannot be undertaken independently in general

The precautionary principle as a heuristic patch

In this paper we attempt to recover an integrated conception of the Precautionary Principle (PP). The α=.05 inferential-threshold convention widely employed in science is ill-suited to the requirements of policy decision making because it is fixed and unresponsive to the cost trade-offs that are the defining concern of policy decision making. Statistical decision theory - particularly in its Signal-Detection Theory (SDT) variant - provides a standard framework within which to incorporate the (mis)classification costs associated with deciding between intervention and non-intervention. We show that the PP implements preventive intervention in precisely those circumstances where the SDT-based model yields a (1,1) corner solution. Thus the PP can be understood as a heuristic variant of the SDT corner solution, which in turn serves to patch the incongruity between the inferential practices of science and the inferential requirements of policy decision making. Furthermore, SDT's analytical structure directs attention to a small number of variables - (mis)classification costs and prior probabilities - as determinants of the (1,1) corner solution. Subjective biases impinging upon these variables - omission bias, protected values, and the affect heuristic in particular, moderated by the decision maker's industry-aligned (insider) or industry-opposed (outsider) status - combine within SDT to successfully retrodict features of the PP previously considered puzzling, if not inconsistent or incoherent. These psychological biases do not exclude, and may in part reflect, the decision maker's deontological moral beliefs, or indeed social norms embodied in the nation's legal system (common law vs. civil law)

A Resolution of Emissions-Estimate Confusion for Informing Flight Choice

Air transport Greenhouse Gas (GHG) emissions estimates differ greatly, depending on the calculation method employed. Among the IPCC, ICAO, DEFRA, and BrighterPlanet calculation methods, the largest estimate may be up to 4.5 times larger than the smallest. Such heterogeneity – and ambiguity over the true estimate – confuses the consumer, undermining the credibility of emissions estimates in general. Consequently, GHG emissions estimates do not currently appear on the front page of flight search-engine results. Even where there are differences between alternative flights’ emissions, this information is unavailable to consumers at the point of choice. When external considerations rule out alternative travel-modes, the relative ranking of flight options’ GHG emissions is sufficient to inform consumers’ decision making. Whereas widespread agreement on a gold standard remains elusive, the present study shows that the principal GHG emissions calculation methods produce consistent rankings within specific route-structure classes. Hence, for many consumers, the question of which calculation method to employ is largely irrelevant. But unless GHG emissions information is displayed at the point of decision, it cannot enter into consumers’ decision making. A credible and ambiguity-free alternative would thus be to display GHG ranking information on the front page of flight search-engine results

Pre-Decision Side-Bet Sequences

Risk-averse Expected Utility (EU) decision makers with wealth-dependent utility functions may find themselves indifferent between accepting and rejecting an indivisible risky prospect. Bell (1988) showed that under these circumstances it is EU-enhancing for the decision maker to engage in a pre-decision side bet, accepting the indivisible risky prospect conditional upon winning the side bet. The side bet places the decision maker on the convex hull between the initial-wealth utility function and the utility function with risky-prospect-augmented wealth. We show that decision makers restricted to actuarially unfair side bets engage in a sequence of individually EU-enhancing side bets. This occurs because optimal stake size is modest for actuarially unfair side bets, whereby wealth remains within the interval of interim convexity upon losing the side bet. As optimal stake size falls strongly with each successive side-bet round, wealth remains within the interval of interim convexity. The EU enhancement conferred by each successive round is also strongly diminishing. Hence the side-bet sequence is eventually truncated when no further EU enhancement is available

Pre-Decision Side-Bet Sequences

Risk-averse Expected Utility (EU) decision makers with wealth-dependent utility functions may find themselves indifferent between accepting and rejecting an indivisible risky prospect. Bell (1988) showed that under these circumstances it is EU-enhancing for the decision maker to engage in a pre-decision side bet, accepting the indivisible risky prospect conditional upon winning the side bet. The side bet places the decision maker on the convex hull between the initial-wealth utility function and the utility function with risky-prospect-augmented wealth. We show that decision makers restricted to actuarially unfair side bets engage in a sequence of individually EU-enhancing side bets. This occurs because optimal stake size is modest for actuarially unfair side bets, whereby wealth remains within the interval of interim convexity upon losing the side bet. As optimal stake size falls strongly with each successive side-bet round, wealth remains within the interval of interim convexity. The EU enhancement conferred by each successive round is also strongly diminishing. Hence the side-bet sequence is eventually truncated when no further EU enhancement is available