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Explaining the anomalies of the exponential discounted utility model

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  • Ali al-Nowaihi

    ()

  • Sanjit Dhami

    ()

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.

Suggested Citation

  • Ali al-Nowaihi & Sanjit Dhami, 2007. "Explaining the anomalies of the exponential discounted utility model," Discussion Papers in Economics 07/09, Department of Economics, University of Leicester.
  • Handle: RePEc:lec:leecon:07/9
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    File URL: http://www.le.ac.uk/economics/research/RePEc/lec/leecon/dp07-9.pdf
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    1. al-Nowaihi, Ali & Dhami, Sanjit, 2006. "A note on the Loewenstein-Prelec theory of intertemporal choice," Mathematical Social Sciences, Elsevier, vol. 52(1), pages 99-108, July.
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    Keywords

    Anomalies of the DU model; Intertemporal choice; Generalized hyperbolic discounting; loss aversion; HARA utility functions; SIE value functions;

    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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