Testing the expected utility maximization hypothesis with limited experimental data
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Transcript of Testing the expected utility maximization hypothesis with limited experimental data
Testing the expected utility maximization hypothesis
with limited experimental data
James B. Coopera, Thomas Russellb,*, Paul A. Samuelsonc
aMathematics Department, Johannes Kepler University, Linz, USAbDepartment of Economics, Santa Clara University,
300 Kenna Hall, Santa Clara, CA 95063, USAcDepartment of Economics, Massachusetts Institute
of Technology, Cambridge, MA, USA
Received 4 April 2003; received in revised form 1 December 2003; accepted 8 December 2003
Abstract
In this article we use some old ideas of Franklin to derive the partial differential equation (St Robert
Equation) characterizing the level curves of expected utility maximizing preferences over simple
gambles. We also provide conditions under which an incomplete family of level curves permits an
investigator to determine whether or not the subject maximizes expected utility and if so under what
conditions preferences can be recovered uniquely.
# 2004 Elsevier B.V. All rights reserved.
Keywords: Expected utility; Limited experimental data; Recovering preferences
1. Introduction
Despite the appeal of its axiomatic foundations, the expected utility maximization
hypothesis is only one among many theories of how individuals take decisions under
uncertainty. To an empiricist, any claim of this hypothesis to preeminence must be based on
its superior predictive performance.
One way to compare such performance is to present an individual with a parameterized
family of probability density functions and ask him/her to indicate those parameter
combinations over which they are indifferent. The resulting family of level curves in
parameter space would presumably have one shape if the individual maximized expected
utility and a different shape if behavior followed some other rule. To exploit such data, of
Japan and the World Economy
16 (2004) 391–407
* Corresponding author. Tel.: þ1-408-554-6953; fax: þ1-408-554-2331.
E-mail address: [email protected] (T. Russell).
0922-1425/$ – see front matter # 2004 Elsevier B.V. All rights reserved.
doi:10.1016/j.japwor.2003.12.005
course, it is necessary to know the mathematical form of the shape of the level curves in the
case in which the subject is an expected utility maximizer (EUM).1
In this paper, we examine a general approach to this question using a neglected technique
due to Franklin (1927). As a by-product of this technique, we examine in detail the
experiment in which the individual reports the certainty equivalence of the gamble in which
they are given equal chances to gain $x and lose $y. We show how to recover the utility
function (up to linear transforms) when expected utility is being maximized in this case.
Finally we address the question of what can be learned when experimental data is limited.
We will show that in this experimental setting, knowing even an infinite number of level
curves is not enough to verify expected utility maximization, though knowledge of three
level curves may be sufficient to rule it out. Moreover, even if we make the strong
assumption that the individual is an EUM, and even if we know an infinite number of level
curves, we cannot determine preferences uniquely, because in this case there can still be an
infinite number of different expected utility maximizing preferences consistent with the
data. We investigate the case of two given level curves in depth and characterize all
possible utility functions consistent with the given curves in this case. The whole paper
may be read as an extension of the recent paper by Samuelson (in press).
2. Franklin’s method
The method developed by Franklin was motivated by a problem in classical physics, but
its relationship to economics is easily seen. Franklin assumed that a family of level curves
in the plane had been obtained experimentally, and asked how we would know if they could
have been generated as the ‘‘indifference curves’’ of a harmonic function H (i.e. a function
of two variables for which Hxx þ Hyy ¼ 0).
To see the relevance of this for the testing of economic behavior, consider the experiment
recently discussed by Samuelson (op.cit.) He examines indifference curves in the para-
meter space x, y, where the set of probability density functions to be evaluated are delta
functions which offer a gain of $x with probability 1/2 and loss of $y with probability 1/2.
Assume initially that these are the level curves z ¼ c of the function
z ¼ f ðx; yÞwhere z gives the dollar equivalent of the gamble. By the nature of the experiment, f is a
symmetric function. An individual will be an EUM if the function f can be recalibrated to
have the form2
12
UðxÞ þ 12
UðyÞ (1)
1 In the case of the ‘‘Matschak/Machina triangle,’’ it is well known that the level curves of an EUM are
parallel straight lines Matschak (1950), Machina (1982) and deviations from this shape can be used to
characterize various non expected utility maximizing models, see Camerer (1995). More generally Schneeweiss
(1966) and Chipman (1973) have discussed the shape of EUM level curves on the parameters of a number of
standard probability density functions including the Gaussian and the LEvy-stable class.2 Technically this requires the existence of a diffeomorphism F with the property that F(f) has this form for a
suitable function U of one variable.
392 J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407
Bearing in mind that a function f of two variables splits as the sum of two separate
functions of the variables (i.e. f (x, y) has the form gðxÞ þ hðyÞ) if and only if (under suitable
smoothness assumptions and for appropriate domains of definition) its mixed partial
derivative @2f=@x@y vanishes, we see that the mathematical question becomes ‘‘When does
a function f of two variables have a reparameterization gðx; yÞ ¼ Fðf ðx; yÞÞ which satisfies
the partial differential equation gxy ¼ 0’’? Fortunately Franklin’s method can be extended
to deal with the general second- order linear partial differential operator as in the following
result.
Theorem 1. We consider the general second-order linear partial differential operator
Lðf Þ ¼P2
i;j¼1aijfij þP2
l¼1bifl where the aij and the bl are smooth functions applied to a
smooth function f (all functions of two variables). We use the subscript notation to denote
partial derivatives (e.g. f11 and f12 denote @2f=@x2 and @2f=@x@y, respectively). Then there
is a recalibration u ¼ F � f of f which satisfies the partial differential equation if and only if
LðuÞ ¼ 0 and only if the expression
Fðf Þ ¼P2
ij¼1aijfij þP2
l¼1blflP2i;j¼1aijfifj
(2)
is constant on the level curves of f.
Proof. Substitute the above operator for the Laplace operator in Franklin’s proof and
follow the steps given there. &
In order to obtain a representation as a partial differential equation we simply take the
directional derivatives of the F(f) along the level curves of f, i.e. in the direction
perpendicular to the gradient of f and set them equal to zero. This leads to the (third-
order) equation:
�f2@
@xþ f1
@
@y
� �Fðf Þ ¼ 0 (3)
It is a routine, if rather tedious, exercise to compute the explicit form of this equation. It can
be done by hand or by using a symbolic differentiation program such as Mathematica. For
our purposes it will suffice to consider some explicit cases where the computations are
quite tractable.
Example 1 (The Samuelson Case). For the experiment presenting the subject with a pair
of equal probability delta functions, we obtain the equation Fðf Þ ¼ fxy=fxfy and so we
obtain the equation:
�fy
@
@x
fxy
fxfy
� �þ fx
@
@y
fxy
fxfy
� �¼ 0 (4)
J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407 393
(In such concrete situations it is more convenient to denote the partials by letter subscripts
than by numerical subscripts). This leads to the equation:3
�f 2y ðfxfxxy � fxyfxxÞ þ f 2
x ðfyfxyy � fxyfyyÞ ¼ 0 (5)
which was obtained by Samuelson.
This equation is one of a number of characterizations of a hexagonal 3-web in the plane.
Here, the 3-web consists of the level curves, the verticals, and the horizontals.4 This
geometrical approach to EUM drawing on the work of Thomsen, Blaschke, and Bol is the
basis of Debreu (1960) implicit characterization of EUM behavior. We return to this point
later.
Example 2 (The Gaussian Case). In this paper, we concentrate on the simple delta
function experiment. To show the power of the Franklin approach, however, we briefly
demonstrate its applicability to experimental curves obtained as the level curves defined on
the parameter space m, s of a family of Gaussians. This case is discussed by Chipman
(op.cit.) and Schneeweiss (op.cit.). The key observation from the Franklin viewpoint is that
the Gaussian family
Nðm; sÞ ¼ s�1ð2pÞ�1=2exp �ðx � mÞ2
2s2
!
satisfies the second-order differential parameter restriction:
s�1 @N
@s¼ @2N
@m2
in the parameters m and s.
Since expected utility is a linear operator on density functions, this restriction will be
inherited by the level curves of an EUM drawn on the family of Gaussians parameterized
by mean and standard deviation.
In our terms, we have
Lðf Þ ¼ @2
@x2� y�1 @
@y
so that the condition is that
fy
ðy � fxxÞf 2x
be constant along level curves. The differential equation is thus
�fy@
@x
fy
ðy � fxxÞf 2x
� �þ fx
@
@y
fy
ðy � fxxÞf 2x
� �¼ 0 (6)
3 Professor Goldberg has pointed out that in web geometry this equation is known as the St. Robert equation,
see Akivis and Shelekhov (1992, p. 43).4 A very fruitful alternative characterization notes that the Blaschke/Chern curvature 2-form of this 3-web
must be zero, see Russell (2003).
394 J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407
which leads to the equation
fxfy
fxy
y � fxxx
� �� f 2
x
yfyy � fy
y2 � fyxx
� �þ 2
fy
y � fxx
� �ðfxfxx � fyfxxÞ ¼ 0 (7)
cf. Chipman (op.cit.) Eq. (2.33). This equation is necessary but not sufficient. Sufficient
conditions are given by Chipman (op.cit.).
Clearly we may apply this approach to any family of density functions so long as there
is some parameterization which satisfies a second-order partial differential restriction.
Of course, this approach can also be applied to suitable systems of equations and to
equations in higher dimensions (this was one of the reasons for the use of the summation
notation in the formulation of Theorem 1). Thus, the authors have computed ‘‘uncali-
brated’’ versions of the Cauchy–Riemann equations (i.e. equations which determine
when the level curves of two given functions u and v are in fact the level curves of the
real and imaginary parts of an analytic function) and the Laplacian operator in higher
dimensions. Interestingly, in the latter case the uncalibrated version of the Laplace
equation is a system of third-order equations. (Details are available from the authors on
request.)
We now return to the Samuelson delta function experiment, however, to show how the
Franklin approach allows us to recover the utility function from the experimental level
curves.
3. Recovering the utility function 1: full information
When we are given a family of level curves which satisfy the Samuelson PDE (5), we can
be certain that some expected utility function is being maximized. We cannot hope to
recover the underlying utility function U uniquely, since any linear transformation aU þ b;
a; b > 0 will describe the underlying preferences just as well. We therefore now show how
to use the experimental level curves to recover U00/U0, the Arrow/Pratt risk aversion
coefficient, from which all members of the class of utility functions representing the same
preferences can be obtained by integration.
We have
Result 1. When a family of level curves satisfies the Samuelson PDE, the Arrow/Pratt risk
aversion coefficient U00/U0 is given by U00=U0 ¼ d log S=dx where S is the slope function
S ¼ fx=fy
Proof. By a simple calculation from Eq. (1) we have F0fx ¼ ð1=2ÞU0 and F00f 2x þ F0fxx ¼
ð1=2ÞU00. Since F00/F0 satisfies the Samuelson PDE, we have F00=F0 ¼ �fxy=fxfy. The
formula then follows by re-arrangement. &
Result 1 sheds light on a number of special cases.
Case 1 (Homotheticity). Suppose that in addition to satisfying the Samuelson PDE, the
family of level curves is homothetic. Then Burk (1936, p. 42) showed that the resulting
J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407 395
utility function was of the class now called in financial economics CRRA, i.e. Constant
Relative Risk Averse.5 This class satisfies �U00=U0 ¼ 1=kx for some constant k. By Result
1, the level curves must therefore satisfy d log S=d log x ¼ r (some constant), i.e. the
elasticity of substitution must be a constant.
Case 2 (HARA). As a generalization of the homothetic level curves, we have the curves
which are homothetic to a point possibly not the origin. Such systems are sometimes
called quasihomothetic. In this case, the utility function belongs to the class of functions
which satisfy the differential equation U00=U0 ¼ 1=gðx � x0Þ By setting x0 ¼ 0 we
recover the CRRA class, and by setting x0 ¼ 1 we have the case of constant absolute
risk aversion CARA.6 Obviously, an EUM will have HARA preferences if and only
if the slope of the experimental level curves satisfies the equation d log S=dx ¼ð1=gðx � x0ÞÞ.
4. Recovering the utility function 2: limited information
When we are given the complete family of level curves of a function which satisfies the
Samuelson PDE (5), we can recover preferences by solving a differential equation. It
remains to discuss what happens if we are given less than complete information. In the
present section, we explore what can be said if we are given a finite number of curves. Two
issues arise.
(1) How much information do we need in order to determine whether or not the
individual is an EUM? This can be regarded as an existence problem—given a finite
family of curves, can they be embedded into a complete family which satisfies
Samuelson’s condition?
(2) If we take it as given that an individual maximizes expected utility, how much
information do we need to determine which utility function describes the preferences?
This can be regarded as a uniqueness problem—we assume a priori that a family of
curves can be embedded into a complete family satisfying Samuelson’s condition and
ask whether the latter family is then unique. (This can be thought of as a type of
boundary problem.)7
In order to deal with these questions, it is very useful to begin by recalling the hexagonal
construction of Blaschke as used by Debreu (op.cit.) (Fig. 1).
The hexagonal condition is used to characterize a special class of 3-web, i.e. a system of
three families of curves in the plane. In our case these are the parallels to the y-axis, the
parallels to the x-axis, and the level curves of our given function f. An individual has EUM
preferences if and only if for any choice of the starting point A in Fig. 1, the web closes, i.e.
5 Of course Burk did not call the function class CRRA since in 1936 this term had not yet been invented. For
the same reason he did not call the function class CES even though in production theory homotheticity þseparability leads to this same functional form, see Sato (1977).
6 The paper by Kim and Omberg (1996) contains a helpful discussion of this case.7 Further boundary conditions are discussed in Samuelson (op. cit.).
396 J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407
G coincides with A. From this construction one can easily give examples of three curves
which cannot be embedded into a hexagonal web. On the other hand, this approach can be
used constructively to extend any two suitable given level curves to an infinite family which
is so embeddable. This can be seen from Fig. 2 where we generate a third (and so
potentially a fourth and so on) by completing the rectangles as shown.
The details may be found in Georgescu-Roegen (GR) (1952) or Samuelson (op.cit.).
When a family of curves is derived from two curves in this manner, we will say that the
given curves form a GR-basis for the family and that the other members of the family are in
the GR-span of these two curves.
Our main result is the following. If we label the first two curves as c0 and c1 then the GR-
construction can be used to embed them into an infinite family labeled by the whole
numbers. We will show how to extend this to a family ca labeled by the real numbers. This
set of curves will form the family of level curves f ¼ a of a suitable function f, and our
construction ensures that f satisfies the Samuelson equation, guaranteeing that the
corresponding web is hexagonal.
Moreover, we shall show that this family is non-unique. We examine this lack of
uniqueness in detail for the simplest case imaginable, i.e. where the two curves c0 and c1 are
the straight lines x þ y ¼ 0 and x þ y ¼ 1. By our existence result, the qualitative aspects
of our statements on lack of uniqueness can be carried over to the general case and we
illustrate this by showing how to do this in the case where our starting point is two
rectangular hyperbolae, say xy ¼ 1 and xy ¼ 2.
A G
Fig. 1. The hexagon construction.
Fig. 2. The Georgescu Roegen construction.
J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407 397
The consequences of this result for the problems we mentioned above can be stated
informally as follows:
Case 1 (The EUM hypothesis when one level curve is known). It is clear from the above
discussion that knowing one level curve of a postulated utility function provides no
information on the EUM hypothesis whatsoever.
In particular, we cannot tell whether the EUM hypothesis is satisfied and even if we
assume a priori that it is, we cannot deduce information about further level curves since we
can choose a second curve at random (within the parameters of our results) and embed it as
below into a full family of curves which satisfy the Samuelson condition.
Case 2 (The EUM hypothesis when two curves are known). Again the knowledge of
two curves alone can provide no information on whether the EUM hypothesis is satisfied or
not and the questions we examine are the following: Given two curves, are we always
permitted to assume that there is some set of EU maximizing preferences whose level
curves include the two given curves, and if so are these EU preferences unique? Stated
more mathematically, this asks: Given two curves, can we embed them into a hexagonal
web and if so, in many ways? The following theorems deal with these questions. The first
covers existence:
Theorem 2. Suppose that we have two diagonally symmetric curves in suitable position
(this will be made precise below). Then there exists a symmetric function z ¼ f ðx; yÞ whose
level curves contain the two given curves and which satisfies the Samuelson equation (so
that its level curves, together with the parallels to the axes as above, form a hexagonal web).
We will sketch a proof of this result in the appendix.8
It follows from this result that there exists a function U which is unique up to a linear
change of variable which is such that the family of curves is the level curves of the function
U(z) where UðzÞ ¼ ð1=2ÞðUðxÞþUðyÞÞ.We now turn to the question of uniqueness. We remark that the web condition that we are
considering is clearly unchanged under the coordinate transformation:
Z ¼ UðzÞ; X ¼ UðxÞ; Y ¼ UðyÞsince this leaves the parallels to the axes unchanged.
This transforms our two initial curves into two of the parallel lines from the family
1=2ðx þ yÞ ¼ c, which we assume for simplicity to be the curves with c ¼ 0 and c ¼ 1.
This can be used to translate the qualitative aspects of the following result on uniqueness
over to the general case:
Theorem 3. Denote the two curves x þ y ¼ 0 and x þ y ¼ 1 by c0 and c1. Then for any
‘‘small perturbation’’ g which satisfies the condition that g is an odd periodic function, i.e.
satisfies the conditions gð�xÞ ¼ �gðxÞ and gðxÞ ¼ gð1 þ xÞ, we have:
8 A more rigorous and complete treatment of the mathematical aspects of this paper is in preparation.
398 J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407
The family of level curves of the function f ðx;yÞ ¼ ð1=2ÞðgðxÞþgðyÞÞ contains c0 and c1
and satisfies Samuelson’s condition. Furthermore, any such family is of this form.
We remark here that the smallness of the perturbation mentioned in the formulation is
such as to ensure that the perturbed identity functionfðxÞ ¼ x þ gðxÞ be a diffeomorphism.
It is, for example, well known that this is the case if the Lipschitz-constant of g is smaller
than one.
Remark. The linear web wðx; yÞ ¼ z associated with any such function V is of the form
f 12ðUðxÞ þ gðUðxÞ
� �þ UðyÞ þ gðUðyÞÞÞÞ ¼ z (8)
where f is the inverse of U þ gðUÞ, this to ensure that on the diagonal of the web
wðx; xÞ ¼ fðx; xÞ ¼ x, a condition required by the nature of the experiment generating the
data.
Example. We illustrate the non-uniqueness result with an example. Suppose that the two
given curves are rectangular hyperbolae. Then of course, there is a simple and natural way
to embed them into a hexagonal web. We simply use the family xy ¼ c since the function
f ðx; yÞ ¼ xy clearly satisfies the Samuelson equation. However, there are many other ways
and Fig. 3 shows a non-hyperbolic family which satisfies this condition and which is
consistent with two given rectangular hyperbolae. In Fig. 4, we show the function h for
which the family forms level sets of the function f ðx; yÞ ¼ ð1=2ÞðhðxÞ þ hðyÞÞ.
Remark 2. The proof of this result given in the Appendix uses an iterative process to
guarantee existence of solutions. This iterative process does not permit the computation of
the function f in terms of elementary functions even when the two given curves are as
simple as x þ y ¼ 0 and the half circle x2 þ y2 ¼ 1.
Remark 3. It is clear from the geometry that if the two initial curves are appropriately
numbered and strictly quasi convex, then the function U can be chosen to be monotonic and
concave. It is then to be expected that if the function g is small enough in a suitable sense,
the utility functions V for the perturbed solutions will retain these properties. For allowable
functions g large enough relative to U, however, the perturbed function may share neither
the monotonicity properties nor the concavity properties of U.
Proof. See Appendix. &
Case 3 (The EUM hypothesis when three (and more) level curves are known). It is
clear from the discussion of the two curve case that the EUM hypothesis is rejectable when
three level curves are given. Since any two level curves constrain the whole family as in the
formulation of Theorem 3, it is possible in principle to examine the third level curve and
check to see if it is included in this set. If not the hypothesis is rejected.
As noted earlier, this is a test ‘‘in principle’’ only. It is not possible in general to derive
the functional form of the family of level curves generated by two level curves, so checking
whether or not a third curve is included in the set is not possible algorithmically. In one
J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407 399
highly specialized case, the hypothesis could be rejected by simple geometry. If three given
curves happened to be amenable to the hexagon construction and the hexagon failed to
close the hypothesis is rejected. This, however, would require an a priori highly unlikely
configuration of the three given curves.
Suppose then that three given curves are consistent with the family of parallelizable curves
given by any two of them. This does not guarantee that the individual is an EUM since we can
now add a fourth curve which at our discretion either is or is not in the EUM family. So,
although three curves can reject the hypothesis, if they do not reject, nothing can be said.
Turning to the question of uniqueness, let us as in the two curve case simply assume that
the hypothesis is satisfied. Does knowing three curves determine preferences uniquely?
Interestingly, because of some very old results on periods in real valued functions due to
Jacobi (1835) the answer to this question depends on which three curves we are given. We
have the following result for the special case where the foliation consists of the family of
parallel lines x þ y ¼ k. (By using the transformation Z ¼ UðzÞ, X ¼ UðxÞ, Y ¼ UðyÞ as
Fig. 3. A non-hyperbolic family generating 2 hyperbolic level curves.
400 J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407
above the general case can be reduced to this one and so the qualitative aspects of the result
can be carried over.)
Theorem 4. Suppose we are given three level curves of an individual who satisfies the
EUM hypothesis. By appropriate choice of coordinates let these curves be given by
x þ y ¼ 0, x þ y ¼ 1, and x þ y ¼ k.
Then
(a) If the third curve is given by x þ y ¼ k, k irrational, preferences are determined
uniquely.
(b) If the third curve is given by x þ y ¼ k, k rational but not an integer, there is more
than one preference system consistent with the three given curves, but a smaller
number of preference systems than were consistent with any two of the curves.
(c) If the third curve is given by x þ y ¼ k, k an integer, no additional information
regarding preferences is added by the third curve.
Proof. Let U(z) be one utility function consistent with the three given curves. Let
VðzÞ ¼ UðzÞ þ gðUðzÞÞ be a potential second utility function. By Theorem 3, since
x þ y ¼ 0 and x þ y ¼ 1, g(�) must have period 1. &
(a) If k is irrational, g(�) must also have period k, where k is irrational. But it is a well
known result that a smooth, non-constant, real valued function cannot have two
distinct periods unless the ratio of the periods is rational. Hence, g(�) is a constant and
preferences are determined uniquely.
2 4 6
-1
1
2
U(W)
Fig. 4. The utility function generating Fig. 3.
J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407 401
(b) In general, if a function has two periods, say l and m, it has period mlþ nm for
integers m and n. It thus has the smallest positive number which has such a
representation as a period. Thus, if k is rational, say of the form p/q, g will have a
period of size 1/q. Clearly, the addition of the third curve reduces the periodicity in
the preference functions consistent with two initially given curves. Indeed for q large,
g will be almost constant and in this case, given that practical measuring devices are
finitely calibrated, we will have uniqueness for all practical purposes.
(c) If k is an integer any third curve is already in the GR span of the other two and so no
new information is added.
This result implies that generically three level curves will determine preferences.
Case 4 (Four and more curves). The analysis of the three curve case is easily expanded to
the case of four or more curves. Depending on the nature of the curve added, it may
determine preferences fully, reduce the degree of indeterminacy in preferences, or, if
unlucky, add no new information.
5. Conclusion
The PDE derived by Samuelson (op. cit.) provides a test of the EUM hypothesis in a
simple experimental setting. In this paper, we have extended this test in two directions.
In the first place, we have shown (using Franklin’s method) that when the Samuelson
PDE is satisfied, it is straightforward to derive the form of the latent utility function. Since
in many applied areas the shape of the utility function is of some importance (for example,
in financial economics dynamic hedging strategies are highly dependent on which class of
utility function applies),9 it is valuable to know how to use this simple experiment to
determine the function class.
In the second place, we have shown that we could be given a great deal of data
(an infinite number of level curves) and still not be able to determine whether or not the
individual maximizes expected utility. Moreover, even if we are told that the individual
does maximize expected utility we may still not be able to determine the underlying
preferences. Since the paper provides the precise bounds on preferences, however, we
could in principle calculate the range of behavior consistent with the maximizing of
expected utility even when we cannot pin down the exact preferences As Samuelson
(op.cit.) notes, there is reason to believe that this range may be quite small.
Acknowledgements
Russell acknowledges the support of a Leavey Grant from Santa Clara University in the
writing of this paper. The authors also wish to thank professor V. Goldberg for comments
on an earlier version.
9 We owe this point to Ed Omberg.
402 J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407
Appendix A.
Proof of Theorem 2. Let A be a suitable subset of R2. A is foliated by the verticals and the
horizontals and we suppose we are given two further curves in suitable position. We will
demonstrate a construction which embeds these two curves into a third foliation which
forms a parallelizable (hexagonal) web with the first two. This third foliation is not unique,
the method of construction yielding all possible foliations.
The central fact that we use is the result that a family uðx; yÞ ¼ c of curves forms a
parallelizable web with the parallels to the coordinate axes if and only if u can be
recalibrated to the form f ðxÞ þ gðyÞ for functions f and g of one variable (Blaschke). When
the foliation is symmetric then uðx; yÞ ¼ uðy; xÞ so that f and g coincide.
There are two steps in the construction. First we show that a given curve together with a
‘‘distance’’ function on this curve can be used to generate a parallelizable web which
includes the given curve. Next we show that two given curves can be used to define a
canonical unit distance. The function which gives distances less than unity can then be
imposed arbitrarily. This fact guarantees existence but not uniqueness, the arbitrariness in
the choice of distance function being equivalent to the ambiguity in preferences
Suppose then that we have a single curve of the form y ¼ f ðxÞ where, for convenience,
we assume that f is defined on the real line. We suppose that we have a strictly increasing,
smooth function r(x) of one variable and regard this as inducing a ‘‘ distance’’ along the
curve by declaring the length of the segment from
ðx; f ðxÞÞ to ð�x; f ð�xÞÞ to be rð�xÞ � rðxÞ for x < �x
We consider the locus of all points P for which the distance QR (in this sense) is constant a(see Fig. 5).
This means that if Q has the coordinates (x, f (x)), then R has the coordinates
ðr�1ðaþ rðxÞÞÞ; f ðr�1ðaþ rðxÞÞÞ
y y=f(x)
Locus of points at a horizontal distance = α from the line
y=f(x) Q P
R
x
ρ
= αρ
Fig. 5. The constant distance foliation
J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407 403
Hence, P is the point (X, Y) where
X ¼ r�1ðaþ rðxÞÞ; Y ¼ f ðxÞThus
x ¼ f�1ðYÞand
x ¼ r�1ðrðXÞ � aÞHence, we have
f�1ðYÞ ¼ r�1ðrðXÞ � aÞor
rf�1ðYÞ � rðXÞ ¼ a
This shows that the foliation generated by all curves which are a constant distance along
the x-axis from a given curve together with the verticals and the horizontals forms a
parallelizable web.
Now suppose that we have two curves in suitable position. We need some restrictions on
the curves to make the construction below work. A sufficient set of restrictions is that the
two curves are defined on the same interval, are monotonic, and have the same limits on the
interval. These restrictions would typically be met in this economic experiment. As we now
show, there is a natural assignment of the distance r ¼ 1 along the curves corresponding
precisely to the GR/S construction. To each possible assignment of a distance function
which gives the distance r ¼ 1 as above, there corresponds a particular parallizable
(hexagon) web, and therefore a particular expected utility preference system. We start with
some base point P0 on the upper curve. Now for any pair of points Q and R on the lower
curve (with R to the right of Q) we define the distance of Q to R to be 1 if the apex P of the
‘‘triangle’’ PQR as described above is on the upper curve (see Fig. 6).
P-1
Distance ρ=1
P1 S
Distance ρ=α
P0
R
Q
Fig. 6. Choosing a distance function.
404 J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407
Since we know what it means to have a distance one along the curve, we can start at P0
and obtain a sequence P1, P2, and so on (by iteration) so that the distance from Pn to
P(nþ1) is always 1. Going to the left we define Pð�1Þ;Pð�2Þ; . . . analogously. We now
know how to define r at these points (namely n at Pn—more precisely at the x-coordinate
of Pn).
We are now free to choose r between P0 and P1 (of course, continuous, strictly
increasing and with value 0 at P0 and 1 at P1).
This then determines r everywhere by the natural extension process.
Thus if S is a point between P0 and P1 where r has the value a, then r has the value 1 þ wa at that point between P1 and P2 whose distance from is 1. Once we have r, the above
construction gives us the required flat web.
If the given curve is symmetric about the diagonal y ¼ x and we choose r to have the
corresponding symmetry properties, then the curves constructed in this manner are also
symmetric. (In this case, we choose P0 to be the intersection of the curve with the diagonal
y ¼ x.)
We now consider uniqueness. Here, we will only consider the symmetric case.
We begin with the case of extrapolating between the two curves x þ y ¼ 0 and
x þ y ¼ 1. All cases can be reduced to this one. Suppose that we have a function f of
one variable so that the level curve
f ðxÞ þ f ðyÞ ¼ 0
corresponds to y ¼ �x and
f ðxÞ þ f ðyÞ ¼ 1
to y ¼ 1 � x.
Then f ð�xÞ þ f ðxÞ ¼ 0, i.e. f ð�xÞ ¼ �f ðxÞ and f ðyÞ ¼ 1 � f ðxÞ ¼ f ð1 � xÞ.Hence, f satisfies the two conditions:
f ð�xÞ þ f ðxÞ ¼ 0 and f ð1 � xÞ þ f ðxÞ ¼ 1
If we write f(x) in the form x þ gðxÞ (i.e. as a perturbation of the identity function), then
these translate into the conditions:
gð�xÞ ¼ �gðxÞ and gð1 � xÞ ¼ �gðxÞfrom which follow that gð1 þ xÞ ¼ gðxÞ, i.e. g is 1 periodic.
Hence, the general solution has the form
f ðxÞ þ f ðyÞ ¼ c
where f ðxÞ ¼ x þ gðxÞ and g is an odd 1 periodic function (so that gð0Þ ¼ 0 ¼ gð1Þ).Periodicity and oddness of g will make it useful to employ the fact that g has a Fourier
sine representation so that f has the form
x þX1n¼1
an sin 2pnx
This representation has been used to illustrate the construction in Mathematica. Details are
available from the authors.
J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407 405
For the following, it will be useful to incorporate more general constants (in place of 0
and 1 above). Thus, if f ðxÞ þ f ðyÞ ¼ c corresponds to y þ x ¼ c and f ðxÞ þ f ðyÞ ¼ d
corresponds to y þ x ¼ d then we have, with
x ¼ ðd � cÞX þ c
2
y ¼ ðd � cÞY þ c
2
(so that X ¼ ð1=ðd � cÞÞðx � ðc=2Þ)
X þ Y ¼ c , 1
d � cðx þ yÞ þ c ¼ c , x þ y ¼ 0
X þ Y ¼ d , 1
d � cðx þ yÞ þ c ¼ d , x þ y ¼ 1
and so the general solution
f ðxÞ ¼ x þX1n¼1
an sin 2pnx
translates into
�f ðxÞ ¼ 1
d � cX � c
2
h iþX1n¼1
an sin 2pn1
d � cX � c
2
h i� �
We illustrate how the general case can be reduced to the above one for the special case
where the two given curves are of the form, say
XY ¼ 1 and XY ¼ 2
Then we use the change of variables x ¼ ln X, y ¼ ln Y so that XY ¼ 1 and XY ¼ 2
correspond to
lnðXYÞ ¼ 0; i:e: x þ y ¼ 0
lnðXYÞ ¼ ln 2; i:e: x þ y ¼ ln 2
This leads to the solution
vðxÞ ¼ ln x=ln 2 þX1n¼1
an sin 2pnðln x=ln 2Þ
Finally we note that the experimental data not only yields a symmetric foliation, but must
also yield the special diagonal calibration f ðx; xÞ ¼ x. Given a function hðxÞ þ gðhðxÞ) with
g(x) as above, however, we can always arrange for this diagonal condition to be satisfied by
choosing a representation U ¼ fðð1=2ÞðhðxÞ þ gðhðxÞÞ þ hðyÞ þ gðhðyÞÞÞ where f is the
inverse of (hðxÞ þ gðhðxÞÞÞ. &
406 J.B. Cooper et al. / Japan and the World Economy 16 (2004) 391–407
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