Anticipated Utility and Rational Expectations as Approximations of Bayesian Decision Making

37 Pages Posted: 18 Feb 2008

See all articles by Timothy Cogley

Timothy Cogley

Leonard N. Stern School of Business - Department of Economics

Thomas J. Sargent

New York University (NYU) - Department of Economics, Leonard N. Stern School of Business; National Bureau of Economic Research (NBER)

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.

Suggested Citation

Cogley, Timothy and Sargent, Thomas J., Anticipated Utility and Rational Expectations as Approximations of Bayesian Decision Making. International Economic Review, Vol. 49, Issue 1, pp. 185-221, February 2008. Available at SSRN: https://ssrn.com/abstract=1093056 or http://dx.doi.org/10.1111/j.1468-2354.2008.00477.x

Timothy Cogley (Contact Author)

Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States
530-752-1581 (Phone)
530-752-9382 (Fax)

Thomas J. Sargent

New York University (NYU) - Department of Economics, Leonard N. Stern School of Business ( email )

269 Mercer Street
New York, NY 10003
United States
212-998-3548 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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