A Failure of the No-Arbitrage
Underlying the principle of no arbitrage is the assumption that markets eliminate any opportunity for risk-free profits. In contrast, we document a pricing mistake by a $200 million company that allowed investors a guaranteed return of 25.6% in a few days, and that resulted in less than $60,000 being invested into exploiting the opportunity.
Joint with Kristóf Madarász and Máté Matolcsi. Appendix. Revised September 2007.
The Impact of Consumer Loss Aversion on PricingAbstract:
We develop a model in which a profit-maximizing monopolist with uncertain cost of production sells to loss-averse, rational consumers. We first introduce techniques for analyzing the demand of such consumers, and then investigate the monopolist’s pricing strategy. Compared to lower possible purchase prices, paying a higher price in the firm’s pricing distribution is assessed by consumers as a loss, decreasing demand for the firm’s product. We provide conditions under which a firm with continuously distributed marginal cost responds by (locally) eliminating this “comparison effect” and choosing a discrete price distribution; that is, prices are “sticky”. Price stickiness is more likely to obtain when the cost distribution has high density, the price responsiveness of demand is low, or consumers are likely to purchase. Whether or not prices are sticky, the monopolist wants to at least mitigate the comparison effect, leading to countercyclical markups. On the other hand, if consumers expect to buy the product, they experience a loss if they end up not consuming it, increasing their willingness to pay for it. Thus, despite the tendency toward price stability, there are also circumstances in which a firm with unchanging cost offers random “sales” to increase customers’ expectation to consume, attracting more demand at higher prices.
Joint with Paul Heidhues. Revised May 2005. The new paper Regular Prices and Sales supersedes this one.
Anticipation in Observable BehaviorAbstract:
This paper asks the natural question: how is utility from anticipation reflected in behavior? I consider a general model of decisionmaking where rationally formed anticipation enters the agent’s utility function in addition to physical outcomes, and allow for interactions between these two payoff components. The paper explores three types of behavior made possible by utility from anticipation, and proves that if a decisionmaker who cares about anticipation is distinguishable from one who only cares about physical outcomes, she has to exhibit at least one of these phenomena. First, the agent can display informational preferences because she is not indifferent to insecurity, or because she cares about future disappointments. I prove that an agent who is indifferent to insecurity always prefers full to partial information if and only if she is disappointment averse, but a stronger condition is needed for her to prefer more information to less. Second, the agent can be time inconsistent because anticipatory feelings pass by the time she has to “invest” in them, and this time inconsistency can be reflected in intransitivity of choices. Third, the agent can be prone to self-fulfilling expectations. In developing these ideas, I also deal with several modeling difficulties when expectations enter utility.
An older, more general, and significantly messier version of "Utility from Anticipation and Personal Equilibrium," Economic Theory.
Ego Utility and Information AcquisitionAbstract:
Based on extensive psychological evidence and the experience of most of us, it seems obvious that people intrinsically care about the perceptions of themselves, not only because it helps in making decisions. This paper explores some of the consequences of this motivation in a model where the agent derives utility from both financial outcomes and her beliefs about her ability (`ego utility'). The model can explain a variety of anomalous-looking behavior, like refusing to consider new information about past judgments, putting off making judgments, and holding on too long to losing decisions. Several applications are discussed, with particular attention to how to provide incentives to employees with ego utility.
Revised January 2001.
Emotional Agency: The Case of the Doctor-Patient
This paper identifies an array of complications in doctor-patient communication that arise when the patient suffers from anxiety. I assume that the patient derives utility from health outcomes as well as the anticipation of the exact same outcomes, and that the doctor wishes to maximize the patient’s utility. The doctor privately (and probabilistically) observes a diagnosis, which affects the optimal treatment. She then sends a message to the patient, who chooses a treatment. While formulated in terms of medical care, this formal model of “emotional agency” also applies to many other situations. If the doctor cannot certifiably convey her diagnosis, communication is endogenously limited to a treatment recommendation, which the doctor distorts toward the treatment that is optimal when the patient is relatively healthy. Paradoxically, more emotional patients get less useful recommendations, even though basing their treatment choice on better recommendations would make them less anxious. If the doctor can certifiably convey her diagnosis, she does so for good news, but unless she needs to “shock” the patient into behaving correctly, she pretends not to know what is going on when the news is bad. If the patient visits two doctors in a row, the second doctor reveals more information than the first one. Results from an original survey of practicing physicians confirm that doctors care about patients’ emotions, and alter their recommendations and other communication in response to them.
An earlier version of "Emotional Agency" (QJE 2006), focused on the doctor-patient relationship
Revised January 2004.