RISK AVERSION,WEALTH, AND BACKGROUND RISK

We use household survey data to construct a direct measure of absolute risk aversion based on the maximum price a consumer is willing to pay for a risky security. We relate this measure to consumer's endowments and attributes and to measures of background risk and liquidity constraints. We find that risk aversion is a decreasing function of the endowment—thus rejecting CARA preferences. We estimate the elasticity of risk aversion to consumption at about 0.7, below the unitary value predicted by CRRA utility. We also find that households' attributes are of little help in predicting their degree of risk aversion, which is characterized by massive unexplained heterogeneity. We show that the consumer's environment affects risk aversion. Individuals who are more likely to face income uncertainty or to become liquidity constrained exhibit a higher degree of absolute risk aversion, consistent with recent theories of attitudes toward risk in the presence of uninsurable risks. (JEL: D1, D8)     

APPLICATIONS OF A RISK AVERSION CONCEPT

In decision theory the concept denoted variously as “risk aversion increment” or “risk premium” has not been fully exploited, although it is neither new nor complex. In this paper we will show how the concept of the risk aversion increment can be used for developing an alternative to the explicit use of the utility function. For most people the use of a risk aversion increment provides a better conceptual reference than does the use of a utility function. To illustrate the usefulness of the concept as a basis for gaining insight into problem statements and their analysis, the following applications are developed: 1) general results for the exponential utility function. 2) estimation of utility functions. 3) general results for various combinations of utility functions and probability distributions. 4) use in sequential decisions. 5) application in the theory of incentives.     

RISK AVERSION AND EXPECTED UTILITY THEORY: AN EXPERIMENT WITH LARGE AND SMALL STAKES

We employ a novel data set to estimate a structural econometric model of the decisions under risk of players in a game show where lotteries present payoffs in excess of half a million dollars. The decisions under risk of players in the presence of large payoffs allow us to estimate the parameters of the curvature of the von Neumann–Morgenstern utility function—not only locally, as in previous studies in the literature, but also globally. Our estimates of relative risk aversion indicate that a constant relative risk aversion parameter of about 1 captures the average of the sample population. We also find that individuals are practically risk neutral at small stakes and risk averse at large stakes—a necessary condition, according to Rabin’s calibration theorem, for expected utility to provide a unified account of individuals’ attitudes toward risk. Finally, we show that for lotteries characterized by substantial stakes, nonexpected utility theories fit the data equally as well as expected utility theory.     

MEASURING MASTER PRODUCTION SCHEDULE STABILITY UNDER ROLLING PLANNING HORIZONS

Maintaining a stable master production schedule (MPS) is difficult for many firms, especially when material requirements planning is used to manage production operations. This paper is concerned with the problem of measuring MPS stability, and the impact on stability of three important decision variables in managing the MPS within a rolling-horizon framework in a make-to-stock environment: the method used to freeze the MPS, the proportion of the MPS frozen, and the length of the planning horizon for the MPS. Simulation experiments conducted to determine the impact of these decision variables, as well as other important product demand and cost characteristics, on MPS stability are reported. The results indicate MPS stability can be influenced by managerial action directed toward management of the MPS as well as changes in important product cost and requirements characteristics.     

RELATIVE RISK AVERSION IS CONSTANT: EVIDENCE FROM PANEL DATA

Most classical tests of constant relative risk aversion (CRRA) based on individual portfolio composition use cross‐sectional data. Such tests must assume that the distributions of wealth and preferences are independent. We use panel data to analyze how individuals’ portfolio allocation between risky and riskless assets varies in response to changes in total financial wealth. We find the elasticity of the risky asset share to wealth to be small and statistically insignificant, supporting the CRRA assumption; this finding is robust when the sample is restricted to households experiencing large income variations. In addition, we find a small but significant negative correlation between wealth and risk aversion. Various extensions are discussed.     

INCENTIVE DESIGN UNDER LOSS AVERSION

Compensation schemes often reward success but do not penalize failure. Fixed salaries with stock options or bonuses have this feature. Yet the standard principal‐agent model implies that pay is normally monotonically increasing in performance. This paper shows that, under loss aversion, there will be intervals over which pay is insensitive to performance, with the use of carrots but not sticks frequently optimal, especially when risk aversion is low and reference income is endogenous. A further benefit of capping losses, for example through options, is to discourage reckless behavior by executives seeking to resurrect their fortunes. (JEL: F3, F4)     

UNCERTAIN DEMAND,CONSUMER LOSS AVERSION,AND FLAT‐RATE TARIFFS

We consider a model of firm pricing and consumer choice, where consumers are loss averse and uncertain about their future demand. Possibly, consumers in our model prefer a flat rate to a measured tariff, even though this choice does not minimize their expected billing amount—a behavior in line with ample empirical evidence. We solve for the profit‐maximizing two‐part tariff, which is a flat rate if (a) marginal costs are not too high, (b) loss aversion is intense, and (c) there are strong variations in demand. Moreover, we analyze the optimal nonlinear tariff. This tariff has a large flat part when a flat rate is optimal among the class of two‐part tariffs.     

PLANNING PROCESS ARCHETYPES AND THEIR EFFECTIVENESS

Case studies of planning were profiled to identify how practitioners carry out a planning process. Five archetype processes emerged from the analyses which were named evaluative, historical model, off-the-shelf, search, and nova. These five processes were compared in terms of their adoption rate and perceived quality. The evaluative process was found to be the most successful, followed by the historical model and off-the-shelf processes. Nova and search processes had the least success. Contextual factors, such as time pressure and resources available, were included in the analyses to identify conditions of use for each process type. In situations where time pressure was high or the planning concerned services, the off-the-shelf model produced the best results; in situations where time pressure was low or the planning concerned internal operations, the historical model produced the best results. Most of the planning activity in organizations appears to be informal and heuristic, ignoring the methods described in the planning literature.     

EXISTENCE AND DERIVATION OF FORECAST HORIZONS IN A DYNAMIC LOT SIZE MODEL WITH NONDECREASING HOLDING COSTS

We are concerned with a discrete-time undiscounted dynamic lot size model in which demand and the production setup cost are constant for an initial few periods and the holding cost of inventory is an arbitrary nondecreasing function assumed to be stationary (i.e., explicitly independent of time) in the same initial few periods. We show that there exists a finite forecast horizon in our model and obtain an explicit formula for it. In addition, we obtain fairly general conditions under which the existence of a solution horizon in the model implies the existence of a forecast horizon. We also derive an explicit formula for the minimal solution horizon. These results extend the earlier ones obtained for the dynamic lot size model with linearly increasing holding costs.     

TREATMENT OF DIFFERENTIAL COSTS AND BENEFITS UNDER RISK

In management accounting texts, the relevant costs and benefits for decision making are usually defined as those future amounts that differ between pairs of alternatives. Use of differential amounts can lead to erroneous choices in decision making under risk. This paper examines conditions under which the use of differential amounts is and is not appropriate.     

CORPORATE RISK MANAGEMENT: A MODEL AND ITS APPLICATION

A problem faced by any corporate risk manager, once he has decided what set of properties will be insured, is to choose among the policies offered by potential insurers. This choice usually involves negotiating with insurers over the exact premium and deductible amounts which will characterize the coverage. In this paper, the problem is modeled in terms of expected utility of different forms of coverage. The model enables a risk manager to select among available terms of coverage and, more significantly, provides guidelines for him in negotiating with the insurers to obtain the best possible terms. As an illustration, an application using real data is described.     

RISK SHARING WITH LIMITED COMMITMENT AND PREFERENCE HETEROGENEITY: STRUCTURAL ESTIMATION AND TESTING

In order to analyze the role of limited commitment and preference heterogeneity in explaining the consumption allocation, I propose a theoretical and empirical framework to estimate and evaluate a risk‐sharing model where insurance transfers have to be self‐enforcing and the coefficient of relative risk aversion may depend on observable household characteristics. I compare this model to benchmark models with full commitment and/or without preference heterogeneity using data from three Indian villages. I find that the limited commitment model with heterogeneous preferences outperforms the benchmark models in a statistical sense and in terms of (i) explaining the dynamic response of consumption to idiosyncratic income shocks, (ii) accounting for the variation of consumption unexplained by household and time effects, and (iii) capturing the variation of inequality across time and villages and predicting changes in inequality. I also use the estimated models to predict the effects of a counterfactual tax and transfer policy on the consumption allocation. The limited commitment model with preference heterogeneity predicts larger benefits to the poor than its homogeneous counterpart. (JEL: C52, D10, D52)     

INCENTIVES,UNCERTAINTY, AND RISK IN THE NEWSBOY PROBLEM

This study explores the motivational consequences of an incentive device based on standard setting. It is shown that standard setting induces a wealth-seeking manager to undertake decisions that, in the manager's judgment, will improve the position of the owner relative to implementing the standard. Conditions under which it is rational for the owner to allow the manager to choose and implement decisions are discussed. Finally, consideration is given to an alternative incentive mechanism in which the manager's decisions are manipulated through variation of the incentive mechanism.     

PRICING RISK IN ECONOMIES WITH HETEROGENEOUS AGENTS AND INCOMPLETE MARKETS

Habit formation has been proposed as a possible solution to the equity premium puzzle. This paper extends the class of models that support the habits explanation in order to account for heterogeneity in earnings, wealth, habits, and consumption. I find that habit formation does indeed increase the equity premium. However, contrary to earlier results, the habit hypothesis does not imply a price for risk as largeas the one measured in the data. There are three reasons for this. First, households in a habits economy modify their consumption/savings decision. Second, they modify their portfolio choice. These two changes in behavior diminish the consumption fluctuations faced by households. Third, the composition of the set of agents pricing risk in the economy changes so that relatively better self‐insured households end up pricing risk. (JEL: D52, G12, E21, C68)     

A SIMULTANEOUS PLANNING MODEL FOR PRODUCTION AND WORKING CAPITAL*

A simultaneous model is proposed for the planning of production, inventory, workforce, and working capital levels over several periods. By exploiting the capabilities of linear programming, the model provides relevant information more efficiently than would be typical of the more traditional approach, in which planning is decomposed along functional lines. A detailed example is presented in order to illustrate the advantages of the simultaneous model.     

RISK SHARING,COMMITMENT, AND INFORMATION: AN EXPERIMENTAL ANALYSIS

This paper describes and analyzes the results of a unique field experiment especially designed to test the effects of the level of commitment and information available to individuals when sharing risk. We find that limiting exogenously provided commitmentis associated with less risk sharing, whereas limiting information on defections can be associated with more risk sharing. These results can be understood by distinguishing between intrinsic and extrinsic incentives, and by recognizing that social sanctions are costly to inflict or that individuals suffer from time‐inconsistent preferences. Comparing the groups formed within our experiment with the real life risk‐sharing networks in a few villages allows us to test the external validity of our experiment and suggests that the results are salient to our understanding of risk‐sharing arrangements observed in developing countries. (JEL: C93, D71, D81, O12)     

INDIVIDUAL RISK ATTITUDES: MEASUREMENT,DETERMINANTS, AND BEHAVIORAL CONSEQUENCES

This paper studies risk attitudes using a large representative survey and a complementary experiment conducted with a representative subject pool in subjects' homes. Using a question asking people about their willingness to take risks “in general”, we find that gender, age, height, and parental background have an economically significant impact on willingness to take risks. The experiment confirms the behavioral validity of this measure, using paid lottery choices. Turning to other questions about risk attitudes in specific contexts, we find similar results on the determinants of risk attitudes, and also shed light on the deeper question of stability of risk attitudes across contexts. We conduct a horse race of the ability of different measures to explain risky behaviors such as holdings stocks, occupational choice, and smoking. The question about risk taking in general generates the best all‐round predictor of risky behavior.