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Affective decision making: a theory of optimism bias

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  • Anat Bracha
  • Donald J. Brown
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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" process. The two processes interact in a simultaneous-move intrapersonal potential game, and observed choice is the result of a pure Nash equilibrium strategy 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 ADM in insurance markets. We prove that ADM potential games are refutable by axiomatizing the ADM potential maximizers.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 10-16.

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    Date of creation: 2010
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    Handle: RePEc:fip:fedbwp:10-16

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    Keywords: Insurance;

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    1. Malcolm Baker & Richard S. Ruback & Jeffrey Wurgler, 2004. "Behavioral Corporate Finance: A Survey," NBER Working Papers 10863, National Bureau of Economic Research, Inc.
    2. Andrew Caplin & John Leahy, 2001. "Psychological Expected Utility Theory And Anticipatory Feelings," The Quarterly Journal of Economics, MIT Press, vol. 116(1), pages 55-79, February.
    3. Brunnermeier, Markus K & Parker, Jonathan A, 2004. "Optimal Expectation," CEPR Discussion Papers 4656, C.E.P.R. Discussion Papers.
    4. Ulrike Malmendier & Geoffrey Tate, 2004. "CEO Overconfidence and Corporate Investment," NBER Working Papers 10807, National Bureau of Economic Research, Inc.
    5. Abraham Neyman, 1997. "Correlated Equilibrium and Potential Games," International Journal of Game Theory, Springer, vol. 26(2), pages 223-227.
    6. Miguel A. Costa-Gomes & Georg Weizsäcker, 2004. "Stated Beliefs and Play in Normal-Form Games," ISER Discussion Paper 0614, Institute of Social and Economic Research, Osaka University.
    7. Miguel A. Costa-Gomes & Georg Weizs�cker, 2008. "Stated Beliefs and Play in Normal-Form Games," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 729-762.
    8. Benhabib, Jess & Bisin, Alberto, 2005. "Modeling internal commitment mechanisms and self-control: A neuroeconomics approach to consumption-saving decisions," Games and Economic Behavior, Elsevier, vol. 52(2), pages 460-492, August.
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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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