<p>I'm not aware of any intuitive justification for the state-non-separability in Epstein-Zin preference. However, as both <a href="https://economics.stackexchange.com/questions/48581/nonseparable-utility-across-states-of-nature-an-intuitive-example#comment78426_48581">@MichaelGreinecker</a> and <a href="https://economics.stackexchange.com/questions/48581/nonseparable-utility-across-states-of-nature-an-intuitive-example#comment78489_48581">@afreelunch</a> alluded to, there are micro/behavioral explanations for why utility is non-separable across states.</p>
<p>Habit formation is the prime example of time non-separability, and it is modeled as <em>current</em> utility being a function of (a set of) <em>past</em> consumption. Likewise, any model in which utility in <em>one state</em> is a function of (a set of) <em>other states</em> would feature state non-separability. Theories that explicitly incorporate disappointment / regret / elation / rejoice are such examples.</p>
<p>If a decision maker (DM) ends up in a state that is worse than what she had anticipated, she may feel <strong>disappointed</strong>; similarly, if the DM ends up in a state that is better than her initial anticipation, she would feel <strong>elated</strong>. Naturally, disappointment and elation are a function of not only the realized state, but also the unrealized ones.</p>
<p>For example, <a href="https://www.jstor.org/stable/2297651" rel="nofollow noreferrer">Loomes and Sugden (1986)</a> posit the following criterion for evaluating lotteries:
<span class="math-container">\begin{equation}
U(L)=\sum_{s\in S}p_s\biggl[u(s)+D\bigl(u(s)-\bar u\bigr)\biggr],\quad\text{where}\;\bar u=\sum_{s\in S}p_su(s).
\end{equation}</span>
Hence, in state <span class="math-container">$s$</span>, the DM gets not only the state utility <span class="math-container">$u(s)$</span>, but also extra (dis)utility depending on how <span class="math-container">$u(s)$</span> compares to the <em>overall expected utility level <span class="math-container">$\bar u$</span></em>. The function <span class="math-container">$D(\cdot)$</span> respects the sign of <span class="math-container">$u(s)-\bar u$</span>. So DM experiences disappointment (and disutility) when she is in a state <span class="math-container">$s'$</span> such that <span class="math-container">$u(s')&lt;\bar u$</span>. Since <span class="math-container">$\bar u$</span> is a function of all states, this formulation makes state non-separable.</p>
<p>In a similar spirit, <a href="https://www.princeton.edu/%7Efgul/g91.pdf" rel="nofollow noreferrer">Gul (1991)</a> derive a criterion with the certainty equivalent as the reference level for disappointment and elation. However, the state non-separability in Gul's criterion is in terms of the probabilities of the states, which show up as decision weights that are nonlinear in the probabilities, rather than wealth levels in those states.</p>
<p>More generally, <a href="https://www.sciencedirect.com/science/article/pii/S2352239918300034" rel="nofollow noreferrer">reference-dependent preferences</a> typically exhibit state non-separability.</p>

CC BY-SA 4.0
2021-12-06T18:19:13.557Z
Cannot we simplify the expressions and represent the utilities of each state without using disappointment and elation? E.g. consider a case of three possible outcomes with utilities $(8,10,12)$ with the middle one being the "default" (expected) state. Why interpret them as $(8,10,12)=(9,10,11)+(-1,0,1)$ where the latter part is due to disappointment ($-1$) and elation ($+1$)? I.e. how can we distinguish between the two possible representations if we only observe the final numbers $(8,10,12)$? (OK, we do not observe utility – these numbers – directly but somehow get to them.)
Richard Hardy
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2021-12-06T18:23:59.110Z
I think my comment reflects that perhaps your answer (or just my understanding of it) is missing a distinction between outcomes and states of nature. Without it, $(9,10,11)+(−1,0,1)$ collapses to $(8,10,12)$ without any way of distinguishing them observationally. Then $(9,10,11)+(−1,0,1)$ is hard to justify since we could start adding even more elements such as $(9,10,10)+(−1,0,1)+(0,0,1)$ and making up additional effects and interpretations of what all these elements are.
Richard Hardy
CC BY-SA 4.0
2021-12-06T18:37:13.757Z
Perhaps the answer in [this](https://economics.stackexchange.com/questions/134/can-the-machina-paradox-be-solved-by-expanding-the-choice-set) thread is relevant.
Richard Hardy
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2021-12-07T01:44:06.240Z
@RichardHardy: Sorry but I'm a bit confused. I thought you wanted an intuitive example that shows utility functions may be non-separable in states. I believe disappoint/elation is such an example: utility in one state is a function of other states. Whether or not one can redefine states and outcomes in such a way that utility is now separable in this alternative definition of states/outcomes is to me a different question. Let me know if I misunderstood anything.
Herr K.
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2021-12-07T07:39:32.220Z
You are right that I am looking for an intuitive example. My problem with yours is that I am not sure it is a valid one. Given what I have read [here](https://economics.stackexchange.com/questions/134), [here](https://math.stackexchange.com/questions/779974) and [here](https://economics.stackexchange.com/questions/48611), I suspect it is not. Now I do not yet understand the topic well enough to be sure about my suspicion. Thus I turn to you with additional questions/comments. I have tried to show that one need not redefine states to turn this example from nonseparable to nonseparable.
Richard Hardy
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2021-12-07T08:18:18.460Z
To cite Martin Van der Linden from two of the threads I have linked to, *To make sense of state dependent utility, you need to have a clear distinction between states and outcomes*. I think this is missing here. Am I wrong? Or do you not agree with the quote and have deliberately not made the distinction?
Richard Hardy
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2021-12-07T20:27:01.740Z
Could you please indicate what definition of nonseparable utility you are using and refer to its source? Thank you.
Richard Hardy
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2021-12-08T01:01:10.253Z
@RichardHardy: I don't think state-dependent utility and utility that's nonseparable in states are the same concept. As for definition of separability (additive and multiplicative), please see both of the answers to [this question](https://economics.stackexchange.com/q/16034/42), as well as [Oliv's comment](https://economics.stackexchange.com/questions/16034/meaning-of-additively-separable-linear-in-x#comment24984_16036) under Alecos' answer. I agree that the outcome vs state distinction is important in certain contexts, but I don't think the context of the linked YT lecture is one.
Herr K.
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2021-12-05T03:34:52.080Z
2021-12-05T03:34:52.080Z
Herr K.
<p>I am new to nonseparable utility across states of nature as found in some macro-financial models (discussed in <a href="https://www.youtube.com/watch?v=kCu11OjYTPA" rel="nofollow noreferrer">this YouTube video lecture</a> by John Cochrane). I do not find the notion intuitive. Could anyone suggest <strong>an intuitive example</strong> or point to a reference that includes one? (Cochrane does not seem to provide any examples in the video.)</p>

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2021-12-01T17:37:14.557Z
Hi @RichardHardy. My understanding of the best intuitive example is when behaviour is characterised by habit formation. http://home.cerge-ei.cz/petrz/fm/f400n26.pdf. There are many implications of habit formation, but one of I am aware of is in terms of the transmission of monetary policy.
EB3112
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2021-12-01T17:58:52.730Z
@EB3112, your link is about time separability with which I do not have a problem at the moment. My question is about separability across states of nature.
Richard Hardy
CC BY-SA 4.0
2021-12-01T18:03:22.570Z
Oh right. Apologies. Are you referring to 'states of nature' as in the ensemble of potentially different outcomes at each time interval $t_i$, yet we only observe one potential draw from this ensemble? If so, I have not seen that captured in a utility function before. Apologies again.
EB3112
CC BY-SA 4.0
2021-12-01T18:25:44.003Z
I think people disagree on whether intuitive examples exist or not. But there is a huge literature on non-expected-utility preferences, mostly outside macro.
Michael Greinecker
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2021-12-01T20:16:33.183Z
@MichaelGreinecker, well, if that literature contains an intuitive example of nonseparable utility across states, then I would appreciate any such reference.
Richard Hardy
CC BY-SA 4.0
2021-12-01T20:17:43.903Z
@EB3112, yes, your interpretation matches my understanding of what nonseparable utility across states means. It seems to be somewhat popular in macro-finance.
Richard Hardy
CC BY-SA 4.0
2021-12-03T18:42:02.423Z
This is quite a famous example: https://everything2.com/title/Machina%2527s+Paradox
afreelunch
CC BY-SA 4.0
2021-12-04T03:36:04.247Z
@afreelunch: You should write an answer out of it.
Herr K.
<macroeconomics><utility><asset-pricing>
Nonseparable utility across states of nature: an intuitive example
Richard Hardy
# Nonseparable utility across states of nature: an intuitive example

(Asked by: username_0 on 2021-12-01)

I am new to nonseparable utility across states of nature as found in some macro-financial models (discussed in [this YouTube video lecture](https://www.youtube.com/watch?v=kCu11OjYTPA) by John Cochrane). I do not find the notion intuitive. Could anyone suggest **an intuitive example** or point to a reference that includes one? (Cochrane does not seem to provide any examples in the video.)

**Tags:** macroeconomics, utility, asset-pricing
> **Comments:**
> **username_1**: Hi @RichardHardy. My understanding of the best intuitive example is when behaviour is characterised by habit formation. http://home.cerge-ei.cz/petrz/fm/f400n26.pdf. There are many implications of habit formation, but one of I am aware of is in terms of the transmission of monetary policy.  
> **username_0**: @EB3112, your link is about time separability with which I do not have a problem at the moment. My question is about separability across states of nature.  
> **username_1**: Oh right. Apologies. Are you referring to 'states of nature' as in the ensemble of potentially different outcomes at each time interval $t_i$, yet we only observe one potential draw from this ensemble? If so, I have not seen that captured in a utility function before. Apologies again.  
> **username_2**: I think people disagree on whether intuitive examples exist or not. But there is a huge literature on non-expected-utility preferences, mostly outside macro.  
> **username_0**: @MichaelGreinecker, well, if that literature contains an intuitive example of nonseparable utility across states, then I would appreciate any such reference.  
> **username_0**: @EB3112, yes, your interpretation matches my understanding of what nonseparable utility across states means. It seems to be somewhat popular in macro-finance.  
> **username_3**: This is quite a famous example: https://everything2.com/title/Machina%2527s+Paradox  
> **username_4**: @afreelunch: You should write an answer out of it.  

---

## 1 answers

### Answer by username_4 on 2021-12-05. Score: 3

I'm not aware of any intuitive justification for the state-non-separability in Epstein-Zin preference. However, as both [@MichaelGreinecker](https://economics.stackexchange.com/questions/48581/nonseparable-utility-across-states-of-nature-an-intuitive-example#comment78426_48581) and [@afreelunch](https://economics.stackexchange.com/questions/48581/nonseparable-utility-across-states-of-nature-an-intuitive-example#comment78489_48581) alluded to, there are micro/behavioral explanations for why utility is non-separable across states.

Habit formation is the prime example of time non-separability, and it is modeled as *current* utility being a function of (a set of) *past* consumption. Likewise, any model in which utility in *one state* is a function of (a set of) *other states* would feature state non-separability. Theories that explicitly incorporate disappointment / regret / elation / rejoice are such examples.

If a decision maker (DM) ends up in a state that is worse than what she had anticipated, she may feel **disappointed**; similarly, if the DM ends up in a state that is better than her initial anticipation, she would feel **elated**. Naturally, disappointment and elation are a function of not only the realized state, but also the unrealized ones.

For example, [Loomes and Sugden (1986)](https://www.jstor.org/stable/2297651) posit the following criterion for evaluating lotteries:
\begin{equation}
U(L)=\sum\_{s\in S}p\_s\biggl[u(s)+D\bigl(u(s)-\bar u\bigr)\biggr],\quad\text{where}\;\bar u=\sum\_{s\in S}p\_su(s).
\end{equation}
Hence, in state $s$, the DM gets not only the state utility $u(s)$, but also extra (dis)utility depending on how $u(s)$ compares to the *overall expected utility level $\bar u$*. The function $D(\cdot)$ respects the sign of $u(s)-\bar u$. So DM experiences disappointment (and disutility) when she is in a state $s'$ such that $u(s')<\bar u$. Since $\bar u$ is a function of all states, this formulation makes state non-separable.

In a similar spirit, [Gul (1991)](https://www.princeton.edu/%7Efgul/g91.pdf) derive a criterion with the certainty equivalent as the reference level for disappointment and elation. However, the state non-separability in Gul's criterion is in terms of the probabilities of the states, which show up as decision weights that are nonlinear in the probabilities, rather than wealth levels in those states.

More generally, [reference-dependent preferences](https://www.sciencedirect.com/science/article/pii/S2352239918300034) typically exhibit state non-separability.

> **Comments:**
> **username_0**: Cannot we simplify the expressions and represent the utilities of each state without using disappointment and elation? E.g. consider a case of three possible outcomes with utilities $(8,10,12)$ with the middle one being the "default" (expected) state. Why interpret them as $(8,10,12)=(9,10,11)+(-1,0,1)$ where the latter part is due to disappointment ($-1$) and elation ($+1$)? I.e. how can we distinguish between the two possible representations if we only observe the final numbers $(8,10,12)$? (OK, we do not observe utility – these numbers – directly but somehow get to them.)  
> **username_0**: I think my comment reflects that perhaps your answer (or just my understanding of it) is missing a distinction between outcomes and states of nature. Without it, $(9,10,11)+(−1,0,1)$ collapses to $(8,10,12)$ without any way of distinguishing them observationally. Then $(9,10,11)+(−1,0,1)$ is hard to justify since we could start adding even more elements such as $(9,10,10)+(−1,0,1)+(0,0,1)$ and making up additional effects and interpretations of what all these elements are.  
> **username_0**: Perhaps the answer in [this](https://economics.stackexchange.com/questions/134/can-the-machina-paradox-be-solved-by-expanding-the-choice-set) thread is relevant.  
> **username_4**: @RichardHardy: Sorry but I'm a bit confused. I thought you wanted an intuitive example that shows utility functions may be non-separable in states. I believe disappoint/elation is such an example: utility in one state is a function of other states. Whether or not one can redefine states and outcomes in such a way that utility is now separable in this alternative definition of states/outcomes is to me a different question. Let me know if I misunderstood anything.  
> **username_0**: You are right that I am looking for an intuitive example. My problem with yours is that I am not sure it is a valid one. Given what I have read [here](https://economics.stackexchange.com/questions/134), [here](https://math.stackexchange.com/questions/779974) and [here](https://economics.stackexchange.com/questions/48611), I suspect it is not. Now I do not yet understand the topic well enough to be sure about my suspicion. Thus I turn to you with additional questions/comments. I have tried to show that one need not redefine states to turn this example from nonseparable to nonseparable.  
> **username_0**: To cite Martin Van der Linden from two of the threads I have linked to, *To make sense of state dependent utility, you need to have a clear distinction between states and outcomes*. I think this is missing here. Am I wrong? Or do you not agree with the quote and have deliberately not made the distinction?  
> **username_0**: Could you please indicate what definition of nonseparable utility you are using and refer to its source? Thank you.  
> **username_4**: @RichardHardy: I don't think state-dependent utility and utility that's nonseparable in states are the same concept. As for definition of separability (additive and multiplicative), please see both of the answers to [this question](https://economics.stackexchange.com/q/16034/42), as well as [Oliv's comment](https://economics.stackexchange.com/questions/16034/meaning-of-additively-separable-linear-in-x#comment24984_16036) under Alecos' answer. I agree that the outcome vs state distinction is important in certain contexts, but I don't think the context of the linked YT lecture is one.  

---

