1
Regret Aversion & Dynamic Choice
PhD Upgrade Presentation
29th February 2008
Stephen Lovelady
Department of Economics
2
Why Regret Aversion?
~ The undergraduate approach...
“You can't regret what
you can't remember.”
Lisa Birnbach (author)
~ Unfortunately little economic content
~ But probably quite enjoyable
~ Some explanatory power
~ Explains presenter's sobriety
Introductio
3
Why Regret Aversion?
~ The PhD approach
“Regret is insight that
comes a day too late.”
Anonymous
~ Considerations of regret are part of the
decision making process
~ But do they come “a day too late”?
~ If we can anticipate regret, how does our
decision making change?
Introductio
4
Motivation for the research
~ Paper for Behavioural Economics
~ “Thoughts on Extending Present Bias
Preferences to Continuous Time”
~ Highlighted two problems
~ How do you define the “present”?
~ When can individuals make decisions?
~ Can psychological factors play a role?
~ Specifically regret of a wrong decision
Introductio
5
Parallels in the literature
~ Concept of “preference reversal”
~ Can occur in quasi-hyperbolic
discounting models
~ What is optimal in one time period is not in
the next
~ Can occur with regret theory
~ Cyclical preferences caused by anticipated regret
~ Behavioural Economics paper suggests
they may be related
Introductio
6
Primary Questions
“Is it possible to construct a theoretically stable
and empirically useful model of continuous time
quasi-hyperbolic discounting?”
“Is it possible to construct a dynamic framework
for decision making with regret aversion?”
Introductio
7
Secondary Questions
“Is it possible to create a definition of the
'present' for use in quasi-hyperbolic discounting
models, based on psychological factors?”
“By what method are individuals able to learn
and adapt their decision making process in a
repeated dynamic context?”
Introductio
8
Plan for the presentation
~ Outline the development of Regret Theory
~ Outline existing problems in the literature
~ Introduce the mechanisms of Regret Theory
~ Outline the development of Discounting Models
~ Propose how to bring the models together
~ Suggest examples where the model is
relevant
Introductio
9
Non-EUT Models
~ Empirical evidence suggests systematic
violations of Expected Utility Theory (EUT)
~ Whole class of models (Non-EUT) which relax
assumptions of EUT
~ Excellent summary by Starmer (JEL, 2000)
~ Makes several points which support my work
~ Regret Theory is just one proposed model
~ Disappointment Aversion
~ Complementary to Regret Theory
Regret Theory
10
Regret Theory
~ Simultaneous work by Bell (1982) and
Loomes & Sugden (1982)
~ Based on modifying the utility function to
include a psychological “regret” term
~ Both papers use the same approach
~ I use the Loomes & Sugden framework without loss of
generality
~ The model can explain the EUT violations
suggested by Kahneman & Tversky (1979)
Regret Theory
11
Regret Theory – The Model
~ Modified Utility Function
mijk = cij + R(cij – ckj)
~ Decisions made by comparing Expected MU
n
∑ p j mEkijik =
j= 1
=> Ai is preferred to Ak if
n
∑
j= 1
pj
[ cij – ckj + R(cij – ckj) – R(ckj – cij) ] ≥ 0
~ Regret Aversion => for all z R''(z) > R''(-z)
Regret Theory
12
Regret Theory - Implications
~ Individuals are willing to trade off now to
avoid future potential regret
~ Individuals are disproportionately influenced
by large potential regrets (regret aversion)
~ Not necessarily the same predictions as risk
aversion
~ A descriptive, behavioural model
~ Though axiomatic foundation has been found by
Sugden (1993)
Regret Theory
13
Regret Theory - Development
~ However...
...regret is the result of comparing one's
outcome with a better outcome that would
have occurred had a different alternative been
selected (Tsiros and Mittal, 2000, p.402)
~ Non-EUT is just one situation where regret
occurs
~ What about dynamic models?
~ What about certainty models?
Regret Theory
14
Regret Theory - Problems
~ Information regarding resolution of uncertainty
~ Simonson (1992)
~ What happens if you can't observe the missed
opportunity?
~ Tsiros and Mittal (2000)
~ Counterfactual thinking
~ Feedback Conditional Regret Theory
~ Humphrey (2000)
~ Outcome resolution vs State of the world
resolution
~ How are situations resolved dynamically?
~ Important consideration for my research
Problems in Regret Theory
15
Regret Theory - Problems
~ Status Quo Bias
~ Tsiros and Mittal (2000)
~ Regret is greatest when deviating from the
“status quo” option
~ Omissions versus Commissions
~ Spranca et al. (1991)
~ Individuals can judge an action with the same
outcome differently depending on
whether it is an
omission or a commission
~ Suggests more regret for commissions
~ Is there a reference point in dynamic decisions?
Problems in Regret Theory
16
Regret Theory - Problems
~ Framing effects
~ Starmer and Sugden (1998)
~ Uses “juxtaposition effects” to test Regret
Theory versus other Non-EUT models
~ Results are sensitive, however, to:
~ Event splitting effects
~ Presentation framing effects
~ Hence tough to empirically test such models
~ Is it possible to construct a model to take account of
such
“mental shortcuts”?
Problems in Regret Theory
17
Regret Theory - Mechanisms
~ Consider the “Money-Pump” argument
~ Regret Theory can generate cyclical preferences
~ A is preferred to B is preferred to C is preferred
to A
~ Loomes & Sugden (1987) consider this a static
problem
~ More
likely to
be a case
for dynamic modelling
~ How do
we make
choices
psychologically?
~ Can you learn from past mistakes?
~ Richard, van der Pligt & de Vries (1996)
~ Consider the difference between “evaluative” and
“affective” components,
~ Also consider how they can be anticipated
~ Is regret the “affective” component?
Mechanisms of Regret Theory
18
Discounting Models
~ Second part of my research
~ Excellent summary by Frederick, Loewenstein and
O'Donoghue (2002)
~ Development of a discount rate to encompass all
intertemporal choice parameters
~ Samuelson (1937) described the constant rate
exponential model
T− t
t
U (ct,....cT) =
∑D
k= 0
k u ct
1
k
k
where D(k) =
1
~ Implies Time Consistency of preferences
Discounting & Time Consistency
19
Discounting Models
~ Empirical evidence, however, points to falling
discount rate, not constant
~ Strotz (1955) called this the “intertemporal tussle”
~ Development of a discount rate to encompass all
intertemporal choice parameters
~ Most constant formulation is the “quasihyperbolic” discount model
T− t
Ut(ct,....cT) =
if k=0
∑D
k= 0
k u ct
k
where D(k) =
1
~ Potential for Time
of preferences
βδkInconsistency
if k>0
Discounting & Time Consistency
20
Discounting Models
~ Like Regret Theory, there has been “sideways”
discussion and application
~ Illiquid Assets – Laibson (1997)
~ Procrastination - O'Donoghue and Rabin (1999)
~ Noticeable failure to develop the model in new
contexts
~ Primarily moving from discrete to continuous time
~ Exhaustive list of papers on the topic
~ Karp (Journal of Economic Theory, 2007)
~ ......
~ I aim to reintroduce economics to the area
Discounting & Time Consistency
21
Discounting Models
~ Can we combine elements of discrete and
continuous time?
~ More realistic economic context
~ Discrete decision making, but continuous utility?
~ How do we define “the present”?
~ Graph from Laibson (1997)
~ Highlights the problem faced
~ How do we “join the dots”?
Discounting & Time Consistency
22
Creating the model
~ First start by expanding the “choiceless” or
“basic” utility function
~ We can have an instantaneous utility function
~ eg. a lottery ticket
~ Or have a path of utility
~ receiving xir1, xir2 and xir3 at t=1,2,3
~ xirt can itself be instantaneous or distributed
over the period
~ Hence cir is now a function of xir1, xir2 and xir3
Creating the Model
23
Creating the model
~ The Loomes & Sugden (1982) framework
suggests Ai is preferred to Ak if
∑
pj
[ C(xij1, xij2, xij3) – C(xkj1, xkj2, xkj3) + R(C(xij1, xij2, xij3) – C(xkj1, xkj2, xkj3))
j= r ,b
–
R(C(xkj1, xkj2,
xkj3) – C(xij1, xij2, xij3)) ] ≥ 0
~ Now introduce a decision period, t=0
~ no utility gained at t=0
~ exists one period prior to t=1
=> u(xaj0) = 0 for all a = i,k and j = r,b
~ It is clear that the method of disconting
matters for decision making
Creating the Model
24
Consider the discounting
~ Firstly consider an exponential discounting
model
3
Cτ(xijt=0,1,2,3) =∑
cijτ =t− τ
u(xijt)
t= τ
~ Are preferences still time consistent with the
additional regret term?
∑
0
j= r ,b
[ cij0 – ckj0 + R(cij0 – ckj0) – R(ckj0 – cij0) ] ≥
if and only if
∑
0
pj
j= r ,b
pj
[ cij1 – ckj1 + R(cij1 – ckj1) – R(ckj1 – cij1) ] ≥
Creating the Model
25
Resulting questions
~ Furthermore:
~ Does the definition of regret aversion still hold with
exponential discounting?
~ What conditions are needed on u(.) and R(.) for
regret
aversion and time consistency?
~ Do the same results hold if the uncertainty is
removed from the model?
~ Can we anticpiate and be averse to regret
without
uncertainty?
Creating the Model
26
Consider the discounting
~ Now consider a quasi-hyperbolic model
Cτ(xij
t=0,1,2,3
τ
3
) = cij = u(xij∑τ) +
t− τ
u(xijt)
t τ
~ What conditions on u(.) and R(.) give time
consistency of preferences?
~ What conditions on u(.) and R(.) give time
inconsistency of preferences?
~ Does regret aversion hold with quasihyperbolic discounting?
Creating the Model
27
Further Questions
~ Consider the model from the perspective of
“evaluative” and “affective” choice
~ Richard, van der Pligt and de Vries (1996)
~ Is the same discounting function necessarily used for
the evaluative and affective components?
~ What happens if not?
~ Are the evaluative and affective components
necessarily aligned at the same time points?
~ Do we consider the evaluative component first,
and
then think about the affective consequences?
~ Introduce a time delay into the model
Creating the Model
28
Relevant Examples
~ Alcohol consumption
~ Richard, van der Pligt and de Vries (1996)
“...people may like the idea of going out with friends,
drinking alcohol, and having a good time, but may also
realize that they will regret it early the next morning when
having to get up for work."
~ 3 stage process
~ Precommitment phase
~ Drive, walk or get the bus
~ Drinking phase
~ High level of utility if drunk, low if not
~ Hangover phase
Relevant Examples
29
Relevant Examples
~ How is the decision reached?
at
~ Precommitment device (car) prevents getting drunk
the next stage
~ Present bias preference reversal when getting drunk
~ “I said I wasn't getting drunk tonight, but....”
~ Potential peer pressure effects?
~ Does the hangover induce regret aversion?
~ Being hungover is much worse than not getting
drunk the previous night(?)
Answering the question requires an integrated
model, where none currently exists
Relevant Examples
30
Next Steps
~ Start with pairwise decision
~ Begin with uncertainty
~ look to remove eventually
~ Introduce time into Regret Theory
~ Introduce regret into Exponential and QuasiHyperbolic discounting
~ Develop continuous time Quasi-Hyperbolic
discounting economically rather than
mathematically
~ Remain aware of the problems identified
Next Steps
31
Questions...
Questions