Taste for Variety and Habit Formation in Dynamic Decision Problems and Strategic Interaction

This research project is funded as a Middle East Collaboration by the Deutsche Forschungsgemeinschaft. The Israeli Partner is Prof. Ehud Lehrer at Tel Aviv University.

Background

The analysis of time inconsistent preferences has been challenging microeconomists for decades, yet the consequences of time inconsistent behavior affect all areas of economics, be it macroeconomic models of the business cycle or finance models that explain the equity premium puzzle. In the latter, models of habit formation in which a decision maker prefers to repeat his choice have gained some popularity. These models are, naturally, considering a continuous consumption space in which the decision maker solves a dynamic optimization problem. In this project, we provide a framework of dynamic decision making in which agents’ stage utilities from any out of finitely many outcomes depends both on the outcome itself, and on how often this outcome has been chosen in the past. In a second step we utilize our results to analyze a repeated normal form game in which each player has finally many actions, and the stage utility of any action profile depends, again, both on the profile itself and on its occurences in the past. We allow the stage utility to decrease as the outcome is chosen more often (if the decision maker prefers variety), to increase (if the decision maker prefers familiarity), or to increase, reach a satiation point, and decrease again (if the decision maker prefers novelty and variation). In three subprojects we shall find optimal strategies for a single decision maker, equilibrium behavior in case of several decision makers, and an axiomatic foundation of this form of preferences.

This project has received funding from DFG, project No 461570745