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 and uncertainty, such as expected utility theory, subjective expected utility, and prospect theory. We therefore propose an alternative model of risky and uncertain choice where decision weights-affective or perceived risk-are endogenous. Affective decision making (ADM) is a strategic model of choice under risk and uncertainty 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 strategy Nash equilibrium 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 affective decision making in insurance markets. We prove that ADM potential games are refutable by axiomatizing the ADM potential maximizers. (C) 2011 Elsevier Inc. All rights reserved.