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Optimal Choice and Beliefs with Ex Ante Savoring and Ex Post Disappointment

  • Christian Gollier

    ()

    (Toulouse School of Economics, F-31042 Toulouse Cedex, France)

  • Alexander Muermann

    ()

    (Department of Finance, Accounting and Statistics, Vienna University of Economics and Business, A-1190 Wien, Austria)

We propose a new decision criterion under risk in which individuals extract both utility from anticipatory feelings ex ante and disutility from disappointment ex post. The decision maker chooses his degree of optimism, given that more optimism raises both the utility of ex ante feelings and the risk of disappointment ex post. We characterize the optimal beliefs and the preferences under risk generated by this mental process and apply this criterion to a simple portfolio choice/insurance problem. We show that these preferences are compatible with first-degree and second-degree stochastic dominance and yield a preference for early resolution of uncertainty. Furthermore, they are consistent with observed violations of the independence axiom, such as the preference reversal in the Allais paradox, and predict that the decision maker takes on less risk compared to an expected utility maximizer. Our decision criterion can thus help explain the equity premium puzzle and the preference for low deductibles in insurance contracts.

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File URL: http://dx.doi.org/10.1287/mnsc.1100.1185
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Article provided by INFORMS in its journal Management Science.

Volume (Year): 56 (2010)
Issue (Month): 8 (August)
Pages: 1272-1284

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Handle: RePEc:inm:ormnsc:v:56:y:2010:i:8:p:1272-1284
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  1. Koszegi, Botond & Rabin, Matthew, 2004. "A Model of Reference-Dependent Preferences," Department of Economics, Working Paper Series qt0w82b6nm, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  2. Caplin, Andrew & Leahy, John, 1997. "Psychological Expected Utility Theory and Anticipatory Feelings," Working Papers 97-37, C.V. Starr Center for Applied Economics, New York University.
  3. Gollier Christian, 1995. "The Comparative Statics of Changes in Risk Revisited," Journal of Economic Theory, Elsevier, vol. 66(2), pages 522-535, August.
  4. Andrew Ang & Geert Bekaert & Jun Liu, 2000. "Why Stocks May Disappoint," NBER Working Papers 7783, National Bureau of Economic Research, Inc.
  5. Kopczuk Wojciech & Slemrod Joel, 2005. "Denial of Death and Economic Behavior," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 5(1), pages 1-26, August.
  6. Matthew Rabin, 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Econometrica, Econometric Society, vol. 68(5), pages 1281-1292, September.
  7. Mark J Machina, 1982. ""Expected Utility" Analysis without the Independence Axiom," Levine's Working Paper Archive 7650, David K. Levine.
  8. Miles S. Kimball, 1991. "Standard Risk Aversion," NBER Technical Working Papers 0099, National Bureau of Economic Research, Inc.
  9. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
  10. Akerlof, George A & Dickens, William T, 1982. "The Economic Consequences of Cognitive Dissonance," American Economic Review, American Economic Association, vol. 72(3), pages 307-19, June.
  11. Machina, Mark J, 1987. "Choice under Uncertainty: Problems Solved and Unsolved," Journal of Economic Perspectives, American Economic Association, vol. 1(1), pages 121-54, Summer.
  12. Rothschild, Michael & Stiglitz, Joseph E., 1971. "Increasing risk II: Its economic consequences," Journal of Economic Theory, Elsevier, vol. 3(1), pages 66-84, March.
  13. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
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