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Affective Decision-Making: A Theory of Optimism-Bias

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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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  • Anat Bracha & Donald J. Brown, 2010. "Affective Decision-Making: A Theory of Optimism-Bias," Cowles Foundation Discussion Papers 1759, Cowles Foundation for Research in Economics, Yale University.
  • Handle: RePEc:cwl:cwldpp:1759
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    More about this item

    Keywords

    Affective decision-making; Optimism-bias; ADM potential games; Demand for insurance;
    All these keywords.

    JEL classification:

    • D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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