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

  • Gollier, Christian
  • Muermann, Alexander

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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Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 462.

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Date of creation: 27 Mar 2006
Date of revision: 2009
Publication status: Published in Management Science, vol. 56, n. 8, August 2010, p. 1272-1284.
Handle: RePEc:ide:wpaper:5897
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