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Affective Decision-Making: A Theory of Optimism-Bias

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    Abstract

    Optimism-bias is inconsistent with the independence of decision weights and payoffs found in models of choice under risk, such as expected utility theory and prospect theory. Hence, to explain the evidence suggesting that agents are optimistically biased, we propose an alternative model of risky choice, affective decision-making, where decision weights -- which we label affective or perceived risk -- are endogenized. Affective decision making (ADM) is a strategic model of choice under risk, where we posit two cognitive processes: the "rational" and the "emotional" processes. 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 potential 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.

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    File URL: http://cowles.econ.yale.edu/P/cd/d17b/d1759.pdf
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    Bibliographic Info

    Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1759.

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    Length: 23 pages
    Date of creation: Mar 2010
    Date of revision:
    Handle: RePEc:cwl:cwldpp:1759

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    Related research

    Keywords: Affective decision-making; Optimism-bias; ADM potential games; Demand for insurance;

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    Cited by:
    1. Chatterjee, Sidharta, 2011. "The Neuroeconomics of Learning and Information Processing; Applying Markov Decision Process," MPRA Paper 28883, University Library of Munich, Germany.

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