Explaining the anomalies of the exponential discounted utility model

Ali al-Nowaihi () and Sanjit Dhami ()

No 07/09, Discussion Papers in Economics from Department of Economics, University of Leicester

Abstract: In a major contribution, Loewenstein and Prelec (1992) (LP) set the foundations for the behavioral approach to decision making over time. We show that the LP theory is incompatible with two very useful classes of value functions: the HARA class and the constant loss aversion class. Resultingly, the LP theory has been used infrequently in applications, which have largely used the ß, ? form of hyperbolic preferences. We propose a more general but equally tractable class of utility functions, the simple increasing elasticity (SIE) class, which is compatible with constant loss aversion in a reformulated version of LP. Allowing for reference dependence and different discount rates for gains and losses the SIE class is able to explain impatience, gain-loss asymmetry, magnitude effect, and the delay-speedup asymmetry even under exponential discounting. If combined instead with the (reformulated) LP theory, the SIE class in addition can also explain the common difference effect.

Keywords: Anomalies of the DU model; Intertemporal choice; Generalized hyperbolic discounting; loss aversion; HARA utility functions; SIE value functions (search for similar items in EconPapers)
JEL-codes: C60 D91 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-upt
Date: 2007-09
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