### 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.

Original language | English (US) |
---|---|

Pages (from-to) | 185-221 |

Number of pages | 37 |

Journal | International Economic Review |

Volume | 49 |

Issue number | 1 |

DOIs | |

State | Published - Feb 2008 |

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### ASJC Scopus subject areas

- Economics and Econometrics

### Cite this

*International Economic Review*,

*49*(1), 185-221. https://doi.org/10.1111/j.1468-2354.2008.00477.x

**Anticipated utility and rational expectations as approximations of Bayesian decision making.** / Cogley, Timothy; Sargent, Thomas.

Research output: Contribution to journal › Article

*International Economic Review*, vol. 49, no. 1, pp. 185-221. https://doi.org/10.1111/j.1468-2354.2008.00477.x

}

TY - JOUR

T1 - Anticipated utility and rational expectations as approximations of Bayesian decision making

AU - Cogley, Timothy

AU - Sargent, Thomas

PY - 2008/2

Y1 - 2008/2

N2 - 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.

AB - 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.

UR - http://www.scopus.com/inward/record.url?scp=39149115658&partnerID=8YFLogxK

UR - http://www.scopus.com/inward/citedby.url?scp=39149115658&partnerID=8YFLogxK

U2 - 10.1111/j.1468-2354.2008.00477.x

DO - 10.1111/j.1468-2354.2008.00477.x

M3 - Article

VL - 49

SP - 185

EP - 221

JO - International Economic Review

JF - International Economic Review

SN - 0020-6598

IS - 1

ER -