Affective decision making: A theory of optimism bias

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. JEL Classifications: D01, D81, G22 Anat Bracha, the corresponding author, is an economist at the Federal Reserve Bank of Boston; her e-mail address is [email protected]. Donald J. Brown is the Phillip R. Allen Professor of Economics in the department of economics at Yale University; his e-mail address is [email protected]. This paper, which may be revised, is available on the web site of the Federal Reserve Bank of Boston at http://www.bos.frb.org/economic/wp/index.htm. The authors thank Roger Howe for his theorem on generic convex functions of Legendre type, and Tzachi Gilboa for many valuable comments and suggestions. We have also received useful comments and advice from Eddie Dekel, Ben Polak, Larry Samuelson, and Kristina Shampanier. Bracha would like to thank the Foerder Institute for Economic Research and the Whitebox Foundation for financial support. The views expressed in this paper are those of the author and do not necessarily represent those of the Federal Reserve Bank of Boston or the Federal Reserve System. This version: December 20, 2010 Research Center for Behavioral Economics