Complexity and Bounded Rationality in Individual Decision Problems

I develop a model of endogenous bounded rationality due to search costs, arising implicitly from the decision problem's complexity. The decision maker is not required to know the entire structure of the problem when making choices. She can think ahead, through costly search, to reveal more of its details. However, the costs of search are not assumed exogenously; they are inferred from revealed preferences through choices. Thus, bounded rationality and its extent emerge endogenously: as problems become simpler or as the benefits of deeper search become larger relative to its costs, the choices more closely resemble those of a rational agent. For a fixed decision problem, the costs of search will vary across agents. For a given decision maker, they will vary across problems. The model explains, therefore, why the disparity, between observed choices and those prescribed under rationality, varies across agents and problems. It also suggests, under reasonable assumptions, an identifying prediction: a relation between the benefits of deeper search and the depth of the search. In decision problems with structure that allows the optimal foresight of search to be revealed from choices of plans of action, the relation can be tested on any agent-problem pair, rendering the model falsifiable. Moreover, the relation can be estimated allowing the model to make predictions with respect to how, in a given problem, changes in the terminal payoffs affect the depth of search and, consequently, choices. My approach provides a common framework for depicting the underlying limitations that force departures from rationality in different and unrelated decision-making situations. I show that it is consistent with violations of timing-independence in temporal framing problems, dynamic inconsistency and diversification bias in sequential versus simultaneous choice problems, and with plausible but contrasting risk attitudes across small- and large-stakes gambles.bounded rationality, complexity, search

DO AUCTION BIDS BETRAY EXPECTATIONS-BASED REFERENCE DEPENDENT PREFERENCES? A TEST, EXPERIMENTAL EVIDENCE, AND ESTIMATES OF LOSS AVERSION

In this paper, we provide a novel experimental auction design that exploits an exogenous variation in the probability of winning to test for the presence of expectations-based reference dependent preferences. We prove that (i) in this design, (which is a one parameter modification of a Becker-de Groote-Marschak (BDM) auction), a lower probability of winning will cause a loss averse agent to bid lower, for a large range of intrinsic values for the object. Data from an experiment demonstrate the existence of this effect. The effect would be absent if preferences were 'standard', or if the status quo was the reference point. Thus we contribute to the nascent literature that empirically documents the importance of expectations as a source of reference points. (ii) We further prove that the experimental design enables unique identification of participants' value distribution and loss averse than men. Finally, as a contribution to experimental methodology, we prove that the BDM mechanism will underestimate loss averse participants' values, we quantify the underestimation, and we suggest methods to bound this bias.Auctions, Expectations, Loss Aversion, Reference dependence

CAPITAL DECISIONS WITH TEMPORAL RESOLUTION OF UNCERTAINTY: A MEAN-VARIANCE APPROACH

Financial Economics,

On Measuring the Welfare Cost of Business Cycles

Lucas (1987) argues that the gain from eliminating aggregate fluctuations is trivial. Following Lucas, a number of researchers have altered assumptions on preferences and found that the gain from eliminating business cycles are potentially very large. However, in these exercises little discipline is placed on preference parameters. This paper estimates the welfare cost of business cycles, allowing for potential time-non-separabilities in preferences, where discipline is placed on the choice of preference parameters by requiring that the preferences be consistent with observed fluctuations in a model of business cycles. That is, a theoretical real business cycle world is constructed and the representative agent is then placed in this world. The agent responds optimally to exogenous shocks, given the frictions in the economy. The agent's preference parameters, along with other structural parameters, are estimated using a Bayesian procedure involving Markov Chain Monte Carlo methods. Two main results emerge from the paper. First, the form for the time-non-separability estimated in this paper is very different than the forms suggested and used elsewhere in the literature. Second, the welfare cost of business cycles is close to Lucas's estimate.Business Cycles, Nonseparable preferences, Welfare cost, Markov Chain Monte Carlo

On Measuring the Welfare Cost of Business Cycles

Lucas (1987) argues that the gain from eliminating aggregate fluctuations is trivial. Following Lucas, a number of researchers have altered assumptions on preferences and found that the gain from eliminating business cycles are potentially very large. However, in these exercises little discipline is placed on preference parameters. This paper estimates the welfare cost of business cycles, allowing for potential time-non-separabilities in preferences, where discipline is placed on the choice of preference parameters by requiring that the preferences be consistent with observed fluctuations in a model of business cycles. That is, a theoretical real business cycle world is constructed and the representative agent is then placed in this world. The agent responds optimally to exogenous shocks, given the frictions in the economy. The agent's preference parameters, along with other structural parameters, are estimated using a Bayesian procedure involving Markov Chain Monte Carlo methods. Two main results emerge from the paper. First, the form for the time-non-separability estimated in this paper is very different than the forms suggested and used elsewhere in the literature. Second, the welfare cost of business cycles is close to Lucas's estimate.

A Parsimonious Model of Subjective Life Expectancy

This paper develops a theoretical model for the formation of subjective beliefs on individual survival expectations. Data from the Health and Retirement Study (HRS) indicate that, on average, young respondents underestimate their true survival probability whereas old respondents overestimate their survival probability. Such subjective beliefs violate the rational expectations paradigm and are also not in line with the predictions of the rational Bayesian learning paradigm. We therefore introduce a model of Bayesian learning which combines rational learning with the possibility that the interpretation of new information is prone to psychological attitudes. We estimate the parameters of our theoretical model by pooling the HRS data. Despite a parsimonious parametrization we find that our model results in a remarkable fit to the average subjective beliefs expressed in the data.

A Structural Analysis of Disappointment Aversion in a Real Effort Competition

We develop a novel computerized real effort task, based on moving sliders across a screen, to test experimentally whether agents are disappointment averse when they compete in a real effort sequential-move tournament. We predict that a disappointment averse agent, who is loss averse around her endogenous choice-acclimating expectations-based reference point, responds negatively to her rival's effort. We find significant evidence for this discouragement effect, and use the Method of Simulated Moments to estimate the strength of disappointment aversion on average and the heterogeneity in disappointment aversion across the population.Disappointment aversion, Loss aversion, Reference-dependent preferences, Reference point adjustment, Expectations, Tournament, Real effort experiment, Slider task

A parsimonious model of subjective life expectancy

This paper develops a theoretical model for the formation of subjective beliefs on individual survival expectations. Data from the Health and Retirement Study (HRS) indicate that, on average, young respondents underestimate their true survival probability whereas old respondents overestimate their survival probability. Such subjective beliefs violate the rational expectations paradigm and are also not in line with the predictions of the rational Bayesian learning paradigm. We therefore introduce a model of Bayesian learning which combines rational learning with the possibility that the interpretation of new information is prone to psychological attitudes. We estimate the parameters of our theoretical model by pooling the HRS data. Despite a parsimonious parametrization we find that our model results in a remarkable fit to the average subjective beliefs expressed in the data.subjective survival expectations; ambiguity; Bayesian learning

A Parsimonious Model of Subjective Life Expectancy

This paper develops a theoretical model for the formation of subjective beliefs on individual survival expectations. Data from the Health and Retirement Study (HRS) indicate that, on average, young respondents underestimate their true sur- vival probability whereas old respondents overestimate their survival probability. Such subjective beliefs violate the rational expectations paradigm and are also not in line with the predictions of the rational Bayesian learning paradigm. We therefore introduce a model of Bayesian learning which combines rational learn- ing with the possibility that the interpretation of new information is prone to psychological attitudes. We estimate the parameters of our theoretical model by pooling the HRS data. Despite a parsimonious parametrization we find that our model results in a remarkable fit to the average subjective beliefs expressed in the data.

SHOULD AGRICULTURAL AND RESOURCE ECONOMISTS CARE THAT THE SUBJECTIVE EXPECTED UTILITY HYPOTHESIS IS FALSE?

This paper argues that the subjective expected utility (SEU) hypothesis has serious limitations in both positive and normative analysis. In addition to experimental evidence, we discuss examples where alternatives to the SEU model provide a richer framework for the study problems of choice under uncertainty.Research Methods/ Statistical Methods,