Cognitive Limits and Preferences for Information

Abstract

The structure of uncertainty underlying certain decision problems may be so complex as to elude decision-makers’ full understanding, curtailing their willingness to pay for payoff-relevant information — a puzzle manifesting itself in, for instance, low stock-market participation rates. I present a decision-theoretic method that enables an analyst to identify decision-makers’ information-processing abilities from observing their preferences for information. A decision-maker who is capable of understanding only those events that either almost always or almost never happen fails to attach instrumental value to any information source. On the other hand, non-trivial preferences for information allow perfect identification of the decision-maker’s mental capacity.

Keywords: Value of Information, Mental Capacity, Decision Theory, Identification

JEL Classification: C44, D81, D83, D91, G41