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Priors and Desires: A Model of Payoff

Publication Date:
Jan 2011
Project Programs:
Behavioral Economics

Whatever a person wants to be true affects what she believes to be true, and consequently the decisions she makes. This paper introduces an axiomatic
model of decision making that allows for this possibility, and uses a number of simplifying assumptions to derive a generally applicable formal representation.
In the resulting representation the payoff in an event affects beliefs as if it were part of the evidence about its likelihood. A single parameter determines both
the direction and weight of this `evidence', with positive values corresponding to optimism, and negative values to pessimism. Changes to the payoff consequences of an event amount to new `evidence', and can alter beliefs even in the absence of new information. The magnitude of the bias is greatest in situations that combine high stakes and great uncertainty, and is only indirectly related to the cost in poor decisions. If uncertainty cannot be readily reduced a substantial bias may remain regardless of its consequences. The model can account for a wide range of psychology evidence, including wishful thinking, cognitive dissonance, and unrealistic pessimism. Economic consequences are explored in various settings, such as the economics of crime, where increased punishment may have little or no deterrent value.

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