IDEAS home Printed from https://ideas.repec.org/p/fip/fedbwp/10-16.html
   My bibliography  Save this paper

Affective decision making: a theory of optimism bias

Author

Listed:
  • Anat Bracha
  • Donald J. Brown

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.

Suggested Citation

  • Anat Bracha & Donald J. Brown, 2010. "Affective decision making: a theory of optimism bias," Working Papers 10-16, Federal Reserve Bank of Boston.
    • Handle: RePEc:fip:fedbwp:10-16
    as

    Download full text from publisher

    File URL: http://www.bostonfed.org/economic/wp/wp2010/wp1016.htm
    Download Restriction: no
    File URL: http://www.bostonfed.org/economic/wp/wp2010/wp1016.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Markus K. Brunnermeier & Jonathan A. Parker, 2005. "Optimal Expectations," American Economic Review, American Economic Association, vol. 95(4), pages 1092-1118, September.
    2. David K. Levine & Drew Fudenberg, 2006. "A Dual-Self Model of Impulse Control," American Economic Review, American Economic Association, vol. 96(5), pages 1449-1476, December.
    3. Ulrike Malmendier & Geoffrey Tate, 2005. "CEO Overconfidence and Corporate Investment," Journal of Finance, American Finance Association, vol. 60(6), pages 2661-2700, December.
    4. Klibanoff, Peter & Marinacci, Massimo & Mukerji, Sujoy, 2009. "Recursive smooth ambiguity preferences," Journal of Economic Theory, Elsevier, vol. 144(3), pages 930-976, May.
    5. Miguel A. Costa-Gomes & Georg Weizsäcker, 2008. "Stated Beliefs and Play in Normal-Form Games," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 75(3), pages 729-762.
    6. Mercè Roca & Robin Hogarth & A. Maule, 2006. "Ambiguity seeking as a result of the status quo bias," Journal of Risk and Uncertainty, Springer, vol. 32(3), pages 175-194, May.
    7. Gajdos, T. & Hayashi, T. & Tallon, J.-M. & Vergnaud, J.-C., 2008. "Attitude toward imprecise information," Journal of Economic Theory, Elsevier, vol. 140(1), pages 27-65, May.
    8. Andrew Caplin & John Leahy, 2004. "The supply of information by a concerned expert," Economic Journal, Royal Economic Society, vol. 114(497), pages 487-505, July.
    9. B. Douglas Bernheim & Antonio Rangel, 2004. "Addiction and Cue-Triggered Decision Processes," American Economic Review, American Economic Association, vol. 94(5), pages 1558-1590, December.
    10. Colin F. Camerer & George Loewenstein & Drazen Prelec, 2004. "Neuroeconomics: Why Economics Needs Brains," Scandinavian Journal of Economics, Wiley Blackwell, vol. 106(3), pages 555-579, October.
    11. Malmendier, Ulrike & Tate, Geoffrey, 2008. "Who makes acquisitions? CEO overconfidence and the market's reaction," Journal of Financial Economics, Elsevier, vol. 89(1), pages 20-43, July.
    12. Abraham Neyman, 1997. "Correlated Equilibrium and Potential Games," International Journal of Game Theory, Springer;Game Theory Society, vol. 26(2), pages 223-227.
    13. Roland Bénabou & Jean Tirole, 2005. "Self-Confidence and Personal Motivation," International Economic Association Series, in: Bina Agarwal & Alessandro Vercelli (ed.), Psychology, Rationality and Economic Behaviour, chapter 2, pages 19-57, Palgrave Macmillan.
    14. Thaler, Richard H & Shefrin, H M, 1981. "An Economic Theory of Self-Control," Journal of Political Economy, University of Chicago Press, vol. 89(2), pages 392-406, April.
    15. Fabio Maccheroni & Massimo Marinacci & Aldo Rustichini, 2006. "Ambiguity Aversion, Robustness, and the Variational Representation of Preferences," Econometrica, Econometric Society, vol. 74(6), pages 1447-1498, November.
    16. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    17. Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-587, May.
    18. Peter Klibanoff & Massimo Marinacci & Sujoy Mukerji, 2005. "A Smooth Model of Decision Making under Ambiguity," Econometrica, Econometric Society, vol. 73(6), pages 1849-1892, November.
    19. Daniel Kahneman, 2003. "Maps of Bounded Rationality: Psychology for Behavioral Economics," American Economic Review, American Economic Association, vol. 93(5), pages 1449-1475, December.
    20. Keller, Punam Anand & Block, Lauren Goldberg, 1996. "Increasing the Persuasiveness of Fear Appeals: The Effect of Arousal and Elaboration," Journal of Consumer Research, Journal of Consumer Research Inc., vol. 22(4), pages 448-459, March.
    21. Loewenstein, George & O'Donoghue, Ted, 2004. "Animal Spirits: Affective and Deliberative Processes in Economic Behavior," Working Papers 04-14, Cornell University, Center for Analytic Economics.
    22. Leeat Yariv, 2002. "I'll See It When I Believe It - A Simple Model of Cognitive Consistency," Cowles Foundation Discussion Papers 1352, Cowles Foundation for Research in Economics, Yale University.
    23. Botond Köszegi, 2006. "Ego Utility, Overconfidence, and Task Choice," Journal of the European Economic Association, MIT Press, vol. 4(4), pages 673-707, June.
    24. Monderer, Dov & Shapley, Lloyd S., 1996. "Potential Games," Games and Economic Behavior, Elsevier, vol. 14(1), pages 124-143, May.
    25. Lars Peter Hansen & Thomas J Sargent, 2014. "Robust Control and Model Uncertainty," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 5, pages 145-154, World Scientific Publishing Co. Pte. Ltd..
    26. Akerlof, George A & Dickens, William T, 1982. "The Economic Consequences of Cognitive Dissonance," American Economic Review, American Economic Association, vol. 72(3), pages 307-319, June.
    27. Andrew Caplin & John Leahy, 2001. "Psychological Expected Utility Theory and Anticipatory Feelings," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 116(1), pages 55-79.
    28. , G. & , & ,, 2007. "Coarse contingencies and ambiguity," Theoretical Economics, Econometric Society, vol. 2(4), December.
    29. Malcolm Baker & Richard S. Ruback & Jeffrey Wurgler, 2004. "Behavioral Corporate Finance: A Survey," NBER Working Papers 10863, National Bureau of Economic Research, Inc.
    30. Leeat Yariv, 2001. "Believe and Let Believe: Axiomatic Foundations for Belief Dependent Utility Functionals," Cowles Foundation Discussion Papers 1344, Cowles Foundation for Research in Economics, Yale University.
    31. Howe, Roger, 1982. "Most convex functions are smooth," Journal of Mathematical Economics, Elsevier, vol. 9(1-2), pages 37-39, January.
    32. Isabelle Brocas & Juan D. Carrillo, 2008. "Theories of the Mind," American Economic Review, American Economic Association, vol. 98(2), pages 175-180, May.
    33. Heath, Chip & Tversky, Amos, 1991. "Preference and Belief: Ambiguity and Competence in Choice under Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 4(1), pages 5-28, January.
    34. 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.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Anat Bracha & Donald J. Brown, 2007. "Affective Decision Making: A Behavioral Theory of Choice," Cowles Foundation Discussion Papers 1633R, Cowles Foundation for Research in Economics, Yale University, revised Apr 2009.
    2. Anat Bracha & Donald J. Brown, 2008. "Affective Decision Making and the Ellsberg Paradox," Cowles Foundation Discussion Papers 1667R, Cowles Foundation for Research in Economics, Yale University, revised Aug 2008.
    3. Isabelle Brocas & Juan D. Carrillo, 2008. "The Brain as a Hierarchical Organization," American Economic Review, American Economic Association, vol. 98(4), pages 1312-1346, September.
    4. Gottlieb, Daniel, 2014. "Imperfect memory and choice under risk," Games and Economic Behavior, Elsevier, vol. 85(C), pages 127-158.
    5. Eddie Dekel & Barton L. Lipman, 2010. "How (Not) to Do Decision Theory," Annual Review of Economics, Annual Reviews, vol. 2(1), pages 257-282, September.
    6. Brice Corgnet & Simon Gaechter & Roberto Hernán González, 2020. "Working too much for too little: stochastic rewards cause work addiction," Working Papers 2007, Groupe d'Analyse et de Théorie Economique Lyon St-Étienne (GATE Lyon St-Étienne), Université de Lyon.
    7. Coutts, Alexander, 2019. "Testing models of belief bias: An experiment," Games and Economic Behavior, Elsevier, vol. 113(C), pages 549-565.
    8. Karni, Edi & Maccheroni, Fabio & Marinacci, Massimo, 2015. "Ambiguity and Nonexpected Utility," Handbook of Game Theory with Economic Applications,, Elsevier.
    9. Andrew J. Keith & Darryl K. Ahner, 2021. "A survey of decision making and optimization under uncertainty," Annals of Operations Research, Springer, vol. 300(2), pages 319-353, May.
    10. Bobba, Matteo & Frisancho, Veronica, 2022. "Self-perceptions about academic achievement: Evidence from Mexico City," Journal of Econometrics, Elsevier, vol. 231(1), pages 58-73.
    11. Stefano DellaVigna, 2009. "Psychology and Economics: Evidence from the Field," Journal of Economic Literature, American Economic Association, vol. 47(2), pages 315-372, June.
    12. Kai Barron, 2021. "Belief updating: does the ‘good-news, bad-news’ asymmetry extend to purely financial domains?," Experimental Economics, Springer;Economic Science Association, vol. 24(1), pages 31-58, March.
    13. Frick, Mira & Iijima, Ryota & Le Yaouanq, Yves, 2019. "Boolean Representations of Preferences under Ambiguity," Rationality and Competition Discussion Paper Series 173, CRC TRR 190 Rationality and Competition.
    14. Mira Frick & Ryota Iijima & Yves Le Yaouanq, 2019. "Dispersed Behavior and Perceptions in Assortative Societies," Cowles Foundation Discussion Papers 2180, Cowles Foundation for Research in Economics, Yale University.
    15. Madhav Chandrasekher & Mira Frick & Ryota Iijima & Yves Le Yaouanq, 2022. "Dual‐Self Representations of Ambiguity Preferences," Econometrica, Econometric Society, vol. 90(3), pages 1029-1061, May.
    16. Markus M. Möbius & Muriel Niederle & Paul Niehaus & Tanya S. Rosenblat, 2022. "Managing Self-Confidence: Theory and Experimental Evidence," Management Science, INFORMS, vol. 68(11), pages 7793-7817, November.
    17. Carvalho, M., 2011. "Essays in behavioral microeconomic theory," Other publications TiSEM 97fbb10e-5f12-420b-b8c4-e, Tilburg University, School of Economics and Management.
    18. David K. Backus & Bryan R. Routledge & Stanley E. Zin, 2005. "Exotic Preferences for Macroeconomists," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 319-414, National Bureau of Economic Research, Inc.
    19. Götte, Lorenz & Huffman, David B., 2006. "Incentives and the Allocation of Effort Over Time: The Joint Role of Affective and Cognitive Decision Making," IZA Discussion Papers 2400, Institute of Labor Economics (IZA).
    20. Izhakian, Yehuda, 2017. "Expected utility with uncertain probabilities theory," Journal of Mathematical Economics, Elsevier, vol. 69(C), pages 91-103.

    More about this item

    Keywords

    Insurance;

    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

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fip:fedbwp:10-16. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Spozio (email available below). General contact details of provider: https://edirc.repec.org/data/frbbous.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.