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Explaining the anomalies of the exponential discounted utility model

Listed author(s):
  • Ali al-Nowaihi

    ()

  • Sanjit Dhami

    ()

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.

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File URL: http://www.le.ac.uk/economics/research/RePEc/lec/leecon/dp07-9.pdf
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Paper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number 07/09.

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Date of creation: Sep 2007
Handle: RePEc:lec:leecon:07/9
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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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