Asset Demand Based Tests of Expected Utility Maximization∗

In the neoclassical model of consumer behavior, considerable work has been done investigating when a consumer’s demand behavior can be described as having been derived from utility maximization. However, most discussions are in a certainty world. We expand on prior analyses in an uncertainty setting by providing conditions under which contingent claim and asset demands will be consistent with state independent Expected Utility maximization. The question is addressed using two different traditional approaches. First given the analytical form of the demand functions, we derive necessary and sufficient conditions such that the consumer’s behavior can be rationalized by an Expected Utility function. Second, we provide a necessary and sufficient condition for a finite set of observations on prices, probabilities and quantities to be consistent with Expected Utility maximization for the case of a single commodity in each state. This condition is shown to be analogous to the strong axiom of revealed preference in classical certainty demand theory. For both approaches, we consider the complete and incomplete asset market cases. DOI: https://doi.org/10.1257/aer.104.11.3459 Posted at the Zurich Open Repository and Archive, University of Zurich ZORA URL: https://doi.org/10.5167/uzh-101280 Originally published at: Kübler, Felix; Selden, Larry; Wei, Xiao (2014). Asset Demand Based Tests of Expected Utility Maximization. American Economic Review, 104(11):3459-3480. DOI: https://doi.org/10.1257/aer.104.11.3459 Asset Demand Based Tests of Expected Utility Maximization∗ Felix Kubler University of Zurich Swiss Finance Institute Larry Selden Columbia University University of Pennsylvania Xiao Wei University of Pennsylvania January 27, 2014 Abstract In the neoclassical model of consumer behavior, considerable work has been done investigating when a consumer’s demand can be described as having been derived from utility maximization. We extend prior analyses to an uncertainty setting by providing conditions under which contingent claim and asset demands will be consistent with state independent Expected Utility maximization. One unique feature of our analysis is to allow demands to be functions of probabilities and not just prices and income. First, we provide necessary and suffi cient conditions for a finite set of observations on prices, probabilities and quantities to be consistent with Expected Utility maximization for the case of a single commodity in each state. This condition can be interpreted as being analogous to the strong axiom of revealed preference in classical certainty demand theory. Second, we provide a characterization of the functional form for demand to be rationalized by an Expected Utility function. Third, we give conditions on the Slutsky matrix that are necessary and suffi cient for rationalization by Expected Utility.In the neoclassical model of consumer behavior, considerable work has been done investigating when a consumer’s demand can be described as having been derived from utility maximization. We extend prior analyses to an uncertainty setting by providing conditions under which contingent claim and asset demands will be consistent with state independent Expected Utility maximization. One unique feature of our analysis is to allow demands to be functions of probabilities and not just prices and income. First, we provide necessary and suffi cient conditions for a finite set of observations on prices, probabilities and quantities to be consistent with Expected Utility maximization for the case of a single commodity in each state. This condition can be interpreted as being analogous to the strong axiom of revealed preference in classical certainty demand theory. Second, we provide a characterization of the functional form for demand to be rationalized by an Expected Utility function. Third, we give conditions on the Slutsky matrix that are necessary and suffi cient for rationalization by Expected Utility.