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Forward-looking experimentation of correlated alternatives

Author

Listed:
  • Wong, Yu Fu

    (Department of Economics, University of Pittsburgh)

Abstract

This paper studies how a forward-looking decision maker experiments on unknown alternatives of correlated utilities. The utilities are modeled by a Brownian motion such that similar alternatives yield similar utilities. Experimentation trades off between the continuation value of exploration and the opportunity cost of exploitation. The optimal strategy is to continuously explore unknown alternatives, and then exploit the best known alternative when the one being explored is found to be sufficiently worse than the best one. The decision maker explores unknown alternatives more quickly as they prove to be worse than the best known one. Applied to firm experimentation, my model predicts a conditional version of Gibrat's law and a linear relation between firm size and profitability.

Suggested Citation

  • Wong, Yu Fu, 0. "Forward-looking experimentation of correlated alternatives," Theoretical Economics, Econometric Society.
    • Handle: RePEc:the:publsh:4960
    as

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    File URL: http://econtheory.org/ojs/index.php/te/article/viewForthcomingFile/4960/41105/1
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    More about this item

    Keywords

    Experimentation; Brownian motion; firm dynamics; Gibrat's law;
    All these keywords.

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D30 - Microeconomics - - Distribution - - - General
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory

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