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A value function that explains the magnitude and sign effects

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  • Ali al-Nowaihi

    ()

  • Sanjit Dhami

    ()

Abstract

Two of the anomalies of the exponentially discounted utility model are the 'magnitude effect' (larger magnitudes are discounted less) and the 'sign effect' (a loss is discounted less than a gain of the same magnitude). The literature has followed Loewenstein and Prelec (1992) in attributing the magnitude effect to the increasing elasticity of the value function and the sign effect to a higher elasticity for losses as compared to gains. We provide a simple, tractable, functional form that has these two properties, which we call the simple increasing elasticity value function (SIE). These functional forms underpin the main explanation of the magnitude and sign effects and may aid applications and further theoretical development.

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Bibliographic Info

Paper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number 08/31.

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Date of creation: Sep 2008
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Handle: RePEc:lec:leecon:08/31

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Keywords: Anomalies of the exponentially discounted utility model; the magnitude effect; the sign effect; SIE value functions;

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References

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  1. Laibson, David, 1997. "Golden Eggs and Hyperbolic Discounting," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(2), pages 443-77, May.
  2. Manzini, Paola & Mariotti, Marco, 2004. "A Vague Theory of Choice over Time," IZA Discussion Papers 1228, Institute for the Study of Labor (IZA).
  3. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  4. Shane Frederick & George Loewenstein & Ted O'Donoghue, 2002. "Time Discounting and Time Preference: A Critical Review," Journal of Economic Literature, American Economic Association, vol. 40(2), pages 351-401, June.
  5. Yoram Halevy, 2008. "Strotz Meets Allais: Diminishing Impatience and the Certainty Effect," American Economic Review, American Economic Association, American Economic Association, vol. 98(3), pages 1145-62, June.
  6. Marc Scholten & Daniel Read, 2006. "Beyond discounting: the tradeoff model of intertemporal choice," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 22710, London School of Economics and Political Science, LSE Library.
  7. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, Springer, vol. 5(4), pages 297-323, October.
  8. Loewenstein, George & Prelec, Drazen, 1992. "Anomalies in Intertemporal Choice: Evidence and an Interpretation," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 107(2), pages 573-97, May.
  9. Thaler, Richard, 1981. "Some empirical evidence on dynamic inconsistency," Economics Letters, Elsevier, Elsevier, vol. 8(3), pages 201-207.
  10. Read, Daniel, 2001. " Is Time-Discounting Hyperbolic or Subadditive?," Journal of Risk and Uncertainty, Springer, Springer, vol. 23(1), pages 5-32, July.
  11. Marc Scholten & Daniel Read, 2006. "Discounting by Intervals: A Generalized Model of Intertemporal Choice," Management Science, INFORMS, INFORMS, vol. 52(9), pages 1424-1436, September.
  12. Ok, Efe A. & Masatlioglu, Yusufcan, 2007. "A theory of (relative) discounting," Journal of Economic Theory, Elsevier, Elsevier, vol. 137(1), pages 214-245, November.
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Cited by:
  1. Ali al-Nowaihi & Sanjit Dhami, 2013. "A Theory of Reference Time," Discussion Papers in Economics, Department of Economics, University of Leicester 13/26, Department of Economics, University of Leicester.
  2. Słomczyński, Wojciech & Życzkowski, Karol, 2012. "Mathematical aspects of degressive proportionality," Mathematical Social Sciences, Elsevier, Elsevier, vol. 63(2), pages 94-101.
  3. Ali al-Nowaihi & Sanjit Dhami, 2008. "A general theory of time discounting: The reference-time theory of intertemporal choice," Discussion Papers in Economics, Department of Economics, University of Leicester 08/34, Department of Economics, University of Leicester.

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