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AFFECTIVE DECISION MAKING:A BEHAVIORAL THEORY OF CHOICEByAnat Bracha and Donald J. BrownNovember 2007COWLES FOUNDATION DISCUSSION PAPER NO. 1633COWLES FOUNDATION FOR RESEARCH IN ECONOMICSYALE UNIVERSITYBox 208281New Haven, Connecticut 06520-8281http://cowles.econ.yale.edu/
A
ff
ective Decision Making: A Behavioral Theoryof Choice
Anat Bracha
∗
and Donald J. Brown
†
November 13, 2007
Abstract
A
ff
ective decision-making (ADM) is a refutable and predictive theory of individual choice under risk and uncertainty. It generalizes expected utilitytheory by positing the existence of two cognitive processes – the “rational”and the “emotional” process. Observed choice is the result of their simultaneousinteraction. We present a model of a
ff
ective choice in insurance markets, whererisk perceptions are endogenous.
JEL classi
fi
cation numbers
: D01, D81, G22
Keywords:
A
ff
ective Choice, Endogenous Risk Perception, Expected UtilityTheory, Insurance
∗
The Eitan Berglas School of Economics, Tel Aviv University
†
The Economics Department, Yale University
1
1 Introduction
Behavioral theories of choice seek both to explain past choices as a function of changesin exogenous variables, and given data on past choice behavior, together with aprobability model of the data generating process, to predict future choices. It isin this sense that a
ff
ective decision-making, ADM, is a behavioral theory of choice.A property shared by consumer demand analysis – see part one in Deaton andMuellbauer (1980), but not evident in other strategic models of choice behavior suchas Gul—Pessendorfer (2001), Bernheim—Rangel (2004) or Fudenberg—Levine (2006).ADM is a game-theoretic model of individual decision-making under risk anduncertainty, which generalizes expected utility, and where the probability weights –perceived risk – are endogenous, as implied by optimism bias (Slovic 2000, Weinstein1980). In our model of individual decision-making there are two distinct psycholog-ical processes that mutually determine choice. This approach is inspired in part byKahneman (2003), who proposes two systems of reasoning that di
ff
er in several im-portant aspects, such as emotion. We call these systems of reasoning the
rational process
and the
emotional process
. The rational process coincides with the expectedutility model. That is, for a given risk perception, i.e., perceived probability distrib-ution, it maximizes expected utility. The emotional process is where risk perceptionis formed. In particular, the agent selects an optimal risk perception to balance twocontradictory impulses: (1) a
ff
ective motivation and (2) a taste for accuracy. Thisis a de
fi
nition of motivated reasoning, a psychological mechanism where emotionalgoals motivate agent’s beliefs, e.g., Kunda (1990), and is a source of psychologicalbiases, such as optimism bias. A
ff
ective motivation is the desire to hold a favorablepersonal risk perception – optimism – and is captured by the expected utility term.The desire for accuracy is the mental cost incurred by the agent for holding beliefsother than her
base rate,
given her desire for favorable risk beliefs
.
The base rate isthe belief that minimizes the mental cost function of the emotional process. This isthe agent’s
correct
risk belief, if her risks are objective such as mortality tables.As an application of a
ff
ective decision-making, we present an example of the de-mand for insurance in a world with two states of nature:
B
ad and
G
ood. The relevantprobability distribution in insurance markets is personal risk, hence the demand forinsurance may depend on optimism bias. A
ff
ective choice in insurance markets isde
fi
ned as the insurance level and risk perception which constitute a pure strategyNash Equilibrium of the ADM intrapersonal game.The systematic departure of the ADM model from the expected utility modelallows for both optimism and pessimism in choosing the level of insurance, and shows,consistent with consumer research (Keller and Block 1996), that campaigns intendedto educate consumers on the loss size in the bad state can have the unintendedconsequence that consumers purchase less, rather than more, insurance. Hence, theADM model suggests that the failure of the expected utility model to explain somedata sets may be due to systematic a
ff
ective biases.2
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