Abstract
Optimism bias is inconsistent with the independence of decision weights and payoffs found in models of choice under risk and uncertainty, such as expected utility theory, subjective expected utility, and prospect theory. We therefore propose an alternative model of risky and uncertain choice where decision weights-affective or perceived risk-are endogenous.Affective decision making (ADM) is a strategic model of choice under risk and uncertainty where we posit two cognitive processes-the "rational" and the "emotional" process. The two processes interact in a simultaneous-move intrapersonal potential game, and observed choice is the result of a pure strategy Nash equilibrium in this game. We show that regular ADM potential games have an odd number of locally unique pure strategy Nash equilibria, and demonstrate this finding for affective decision making in insurance markets. We prove that ADM potential games are refutable by axiomatizing the ADM potential maximizers.
| Original language | English |
|---|---|
| Pages (from-to) | 67-80 |
| Number of pages | 14 |
| Journal | Games and Economic Behavior |
| Volume | 75 |
| Issue number | 1 |
| DOIs | |
| State | Published - May 2012 |
| Externally published | Yes |
Bibliographical note
Funding Information:We would like to thank the referee for several helpful comments that clarified our discussion and proofs, Roger Howe for his theorem on generic convex functions of Legendre type, and Tzachi Gilboa for many valuable comments and suggestions. Also, we have received useful comments and advice from Eddie Dekel, Ben Polak, Larry Samuelson, and Kristina Shampanier. Bracha would like to thank the Foerder Institute for Economic Research and the Whitebox Foundation for financial support. The views expressed in this paper are solely those of the authors and not those of the Federal Reserve Bank of Boston or the Federal Reserve System.
Keywords
- Affective expected utility
- Demand for insurance
- Optimism bias