Dynamic Quantile Models of Rational Behavior

56 Pages Posted: 15 Mar 2017 Last revised: 20 Nov 2019

Date Written: March 4, 2019

Abstract

This paper develops a dynamic model of rational behavior under uncertainty, in which the agent maximizes the stream of future τ-quantile utilities, for τ ∈ (0, 1). That is, the agent has a quantile utility preference instead of the standard expected utility. Quantile preferences have useful advantages, including the ability to capture heterogeneity and allowing the separation between risk aversion and elasticity of intertemporal substitution. Although quantiles do not share some of the helpful properties of expectations, such as linearity and the law of iterated expectations, we are able to establish all the standard results in dynamic models. Namely, we show that the quantile preferences are dynamically consistent, the corresponding dynamic problem yields a value function, via a fixed point argument, this value function is concave and differentiable, and the principle of optimality holds. Additionally, we derive the corresponding Euler equation, which is well suited for using well-known quantile regression methods for estimating and testing the economic model. In this way, the parameters of the model can be interpreted as structural objects. Therefore, the proposed methods provide microeconomic foundations for quantile regression methods. To illustrate the developments, we construct an intertemporal consumption model and estimate the discount factor and elasticity of intertemporal substitution parameters across the quantiles. The results provide evidence of heterogeneity in these parameters.

Keywords: Quantile Utility, Dynamic Programming, Quantile Regression, Intertemporal Consumption

JEL Classification: C22, C61, E21

Suggested Citation

de Castro, Luciano I. and Galvao, Antonio F., Dynamic Quantile Models of Rational Behavior (March 4, 2019). Available at SSRN: https://ssrn.com/abstract=2932382 or http://dx.doi.org/10.2139/ssrn.2932382

Luciano I. De Castro

Tippie College of Business ( email )

108 Pappajohn Building
Iowa City, IA 52242
United States

HOME PAGE: http://https://lucianodecastro.net/

Antonio F. Galvao (Contact Author)

University of Arizona ( email )

McClelland Hall, Room 401 1130 E. Helen Street
Tucson, AZ 85721
United States

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