Template-Type: ReDIF-Paper 1.0
Author-Name: Tim W. Cogley
Author-Name-First: Tim W.
Author-Name-Last: Cogley
Author-Name: Thomas J. Sargent
Author-Name-First: Thomas J.
Author-Name-Last: Sargent
Author-Workplace-Name: Department of Economics, University of California Davis
Title: Anticipated Utility and Rational Expectations as Approximations of  Bayesian Decision Making
Abstract: For a Markov decision problem in which unknown transition probabilitiesserve as hidden state variables, we study the quality of two approximations tothe decision rule of a Bayesian who each period updates his subjective distribu-tion over the transition probabilities by Bayes? law. The first is the usual ratio-nal expectations approximation that assumes that the decision maker knows thetransition probabilities. The second approximation is a version of Kreps? (1998)anticipated utility model in which decision makers update using Bayes? law butoptimize in a way that is myopic with respect to their updating of probabili-ties. For a range of consumption smoothing examples, the anticipated utilityapproximation outperforms the rational expectations approximation. The an-ticipated utility and Bayesian models augment market prices of risk relative tothe rational expectations approximation.
Length: 46
File-URL: https://repec.dss.ucdavis.edu/files/9awFRHTxezcix7t2qssZ4YY3/05-23.pdf
File-Format: application/pdf
Number: 68
Classification-JEL: C63, D83, D84
KeyWords: Rational expectations, Bayes? Law, anticipated utility, market price ofrisk
Creation-Date: 20050228
Handle: RePEc:cda:wpaper:68