Anticipated utility and rational expectations as approximations of Bayesian decision making

Timothy Cogley, Thomas J. Sargent

    Research output: Contribution to journalArticle

    Abstract

    We study a Markov decision problem with unknown transition probabilities. We compute the exact Bayesian decision rule and compare it with two approximations. The first is an infinite-history, rational-expectations approximation that assumes that the decision maker knows the transition probabilities. The second is a version of Kreps' anticipated-utility model in which decision makers update using Bayes' law but optimize in a way that is myopic with respect to their updating of probabilities. For several consumption-smoothing examples, the anticipated-utility approximation outperforms the rational expectations approximation. The rational expectations approximation misrepresents the market price of risk.

    Original languageEnglish (US)
    Pages (from-to)185-221
    Number of pages37
    JournalInternational Economic Review
    Volume49
    Issue number1
    DOIs
    StatePublished - Feb 2008

    ASJC Scopus subject areas

    • Economics and Econometrics

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