Publication Date: March 2010
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.
Aﬀective decision-making, Optimism-bias, ADM potential games, Demand for insurance
JEL Classification Codes: D01, D81, G22