DP10123 Perceiving Prospects Properly

Author(s): Jakub Steiner, Colin Stewart
Publication Date: August 2014
Keyword(s): evolution, perception bias, prospect theory
JEL(s): D81, D83
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10123

When an agent chooses between prospects, noise in information processing generates an effect akin to the winner?s curse. Statistically unbiased perception systematically overvalues the chosen action because it fails to account for the possibility that noise is responsible for making the preferred action appear to be optimal. The optimal perception patterns share key features with prospect theory, namely, overweighting of small probability events (and corresponding underweighting of high probability events), status quo bias, and reference- dependent S-shaped valuations. These biases arise to correct for the winner?s curse effect.