Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making

Ying He, James S. Dyer, John C. Butler* Department of Information, Risk, and Operations Management Department of Finance* McCombs School of Business, The University of Texas at Austin, Austin, Texas 78712 ying.he08irom@utexas.edu, j.dyer@mccombs.utexas.edu, butlerjc@mccombs.utexas.edu Abstract: We propose a model to incorporate both anticipation and disappointment into decision making, where we define hope as anticipating a gain and dread as anticipating a loss. In our model, anticipation for a lottery is a subjectively chosen outcome of the lottery that influences the decision makers reference point. The decision maker experiences elation or disappointment when she compares the received outcome with the anticipated outcome. Our model captures the trade-off between a utility gain from higher anticipation and a utility loss from higher disappointment. We show that our model contains some existing decision models as its special cases, including disappointment models. We also use our model to explore how a persons attitude toward the future, either optimistic or pessimistic, could mediate the wealth effect on her risk attitude. Finally, we show that our model can be applied to explain the coexistence of a demand for gambling and insurance and it also provides unique insights into portfolio choice and advertising decision problems. Key words: anticipation, disappointment, risk attitude, optimism and pessimism, utility of gambling, portfolio selection, optimal advertising Hope itself is a species of happiness, and, perhaps, the chief happiness which this world affords; but, like all other pleasures immoderately enjoyed, the excesses of hope must be expiated by pain Samuel Johnson

1. Introduction
When the mega millions jackpot prize reached its highest level of $656 million on March 30 2012, the public experienced lottery fever. The topic #IfIWonTheMegaMillions was trending on Twitter during that week as people anticipated how their life would change in the event that they won the jackpot1. Even though the chance of winning the prize was minuscule 1 in 175,711,536 as listed

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

on the website of www.megamillions.com many people were still willing to pay a few dollars to play it. With a few dollars, they bought hope, which allowed them to dream about what they would do with hundreds of millions of dollars. Dreaming about winning in the days between buying a ticket and learning the outcome of the lottery drawing may have brought more pleasure to the players than using a few dollars to buy a snack or a cup of coffee. Lottery buyers in the Mega Millions lottery experience more utility by anticipating a higher expected payoff from the lottery, because anticipating a favorable result is in itself a pleasurable outcome. This type of behavior is consistent with the theory of utility from anticipation, which is based on the assumption that people not only derive utility when experiencing an outcome but also from anticipating the outcome (Akerlof and Dickens 1982, Loewenstein 1987, Elster and Lowenstein 1992). However, anticipating a higher expected payoff may also result in more disappointment when a player does not win the lottery. Adopting the old saying, Blessed is he who expects nothing, for he shall never be disappointed is consistent with lowering anticipated expected payoff. The notion that a DM can subjectively change her anticipation level for an uncertain payoff has been studied extensively in psychology and behavioral science (Taylor and Shepperd 1998, Van Dijk et al. 2003, Carroll et al 2006). In all of these studies, scholars confirmed that people tend to lower their expectations or predictions for a self-relevant event as the event draws near. Van Dijk et al (2003) hypothesize that people lower their expectations to protect themselves from suffering a major disappointment when the uncertainty of a proximate self-relevant event is resolved. Thus there are two competing cognitive strategies that a decision maker (DM) might employ to increase her experienced utility: savoring a higher anticipated payoff before the uncertainty of the payoff is resolved or anticipating a less desirable payoff to avoid disappointment when the lottery is 2

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

resolved. These two competing strategies have been verified in experimental studies by Loewenstein and Linville (1986). In this paper, we propose a decision making model to capture the tradeoff between these two conflicting strategies that influence the DMs total experienced utility from an uncertain outcome paid in the future. Besides the behavioral findings reviewed above, our research is also closely related to the concept of disappointment (Bell 1985, Loomes and Sugden 1986, Jia et al. 2001). In these disappointment models, a DM anticipates that she will experience either elation or disappointment when the lottery is resolved and paid, depending on whether the realized outcome is superior or inferior to her reference point. The reference point against which the outcome is compared to form elation and disappointment is assumed to be either the mathematical expectation of the lottery (Bell 1985, Jia et al. 2001) or the expected utility of the lottery (Loomes and Sugden 1986). However, these models do not apply to a decision maker who subjectively chooses to lower her expectation to avoid disappointment, as the expectations in these disappointment models are based on objective probabilities. Our model is a special case of a model proposed by Gollier and Muermann (2010), hereafter the GM model, where a DM forms her expectation of the anticipated outcome based on her subjective probabilities. Before the uncertainty of the outcome is resolved, she can savor the anticipation; after the uncertainty is resolved, she experiences either elation or disappointment by comparing the realized payoff with a reference point determined by her subjective expectation. The GM model assumes that the DM chooses an optimal subjective belief to balance the tradeoff between savoring higher expectation and avoiding higher disappointment. This assumption in the GM model is related to the line of research on optimal beliefs in expected utility introduced by Brunnermeier and Parker (2005) and Brunnermeier et al. (2007). We allow for any possible anticipated payoff level in the decision 3

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

making process rather than assume the DM is capable of determining the optimal anticipation to maximize her utility. Savoring anticipation and avoiding disappointment may be only two of many considerations that influence how people form their beliefs about the future. Our model asserts a different process of forming an anticipated outcome to savor than GM, which results in different implications. For example, we show that in a portfolio choice problem our model is consistent with the empirical finding that optimism will lead to more investment in the risky asset relative to the risk free asset (Manju and Robinson 2007, Balasuriya 2010, Nosic and Weber 2010). In contrast, the GM model conflicts with these empirical findings. This conflict is addressed by an extension of the GM model proposed by Jouini et al (2013). However, neither GM nor Jouini et al (2013) propose preference conditions for their models. In contrast, we also develop an axiomatic basis for our model with preference assumptions that can be evaluated for their reasonableness. We refer to the anticipated expected payoff based on a DMs subjective probabilities as the anticipation level. By changing her subjective probabilities over outcomes, the DM could change her anticipation level for a lottery. This anticipation level influences two types of utility derived from a lottery: utility of anticipation and anticipated experienced utility. Utility of anticipation is the pleasure or pain that the DM consumes before the lottery is resolved, where anticipation can be interpreted as a psychological state (Caplin and Leahy, 2001). Anticipated experienced utility is determined based on the DMs prediction of how disappointed or elated she will feel when the lottery is resolved. By incorporating these two types of utility into a unified framework, our model captures four different emotions we may observe in a risky decision context: hope, dread, elation, and disappointment. While elation and disappointment have been modeled in disappointment theory (Bell 1985, Loomes and Sugden 1986, Jia et al 2001, Delqui and Cillo 2006), there are few studies that embed 4

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

hope and dread in a decision model. One exception is Chew and Ho (1994) who did model hope as the preference for the late resolution of the uncertainty in a recursive utility framework. Caplin and Leahy (2001) proposed a very general model that incorporates the utility derived from anticipatory feelings such as anxiety, hope, and suspense in the decision making process. However, they did not allow the anticipatory feelings to influence the decision makers reference point, thus emotions of disappointment and elation are not captured by their model. We model hope as the anticipation of a gain and dread as the anticipation of a loss consistent with Lowenstein (1987). The rest of the paper is organized as follows. In section 2, we introduce a general model and show that a special case of this model is a Risk-Value model (Jia and Dyer 1996). We then make additional assumptions about the components of this general model and obtain a model similar to GM, which also contains Bells (1985) disappointment model as a special case. In section 3, we propose preference conditions to axiomatize the models discussed in section 2, while section 4 discusses the risk attitudes captured by our model that cannot be described by Expected Utility (EU) model and shows that our model can be used to interpret the coexistence of gambling and insurance purchasing without violating either stochastic dominance or transitivity; other existing models for the utility of gambling violate at least one of these conditions. In section 5, we apply our model to portfolio choice and the selection of the optimal advertising level to demonstrate the variety of factors that might affect preference that our model can accommodate. Section 6 concludes the paper. All the proofs are provided in the appendix.

2. The model
to denote a lottery of payoffs and to denote an anticipation level. The In this paper, we use bounded sets of payoffs and anticipation are denoted by and respectively. In general, the anticipation level depends on the lottery, which can be denoted by . Thus, is a function of 5

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

consistent with Caplin and Leahy (2001).However, when it is clear which lottery is associated with the anticipation level we will drop the subscript and simply use . We consider two periods in our model. In the first period, the DM chooses the anticipation level with monetary payoffs that is under consideration. She derives utility from before of the lottery the lottery is resolved by savoring it. In the second period, the lottery is resolved and she experiences either elation or disappointment induced by comparing the received outcome of the lottery with a in the first period is based reference point determined by . Thus, the DMs evaluation of a lottery , ). The total ex ante utility derived from this lottery with an associated on a two attribute vector ( anticipation is evaluated by the DM according to the following model with () > 0 , = )(+ () () (1)

, in this model is decomposed into two parts, the utility of The total ex ante utility (). Since the utility function is anticipation )(and the anticipated experienced utility unique up to an affine transformation, we can rescale it such that (0,0) = 0, (0) = 0, and (0) = 0. This rescaling leads to zero total ex ante utility for the DM when she both anticipates and receives a zero outcome. The function () is a trade-off factor between the two components of the total ex ante , if the DM anticipates > 0, this positive anticipation creates hope for the utility. For a lottery DM; if the DM anticipates < 0, this negative anticipation creates dread. Since this anticipation is is resolved, the reference point used by the DM the outcome the DM anticipates before the lottery to form elation and disappointment should be influenced by this anticipation level. Specifically, we assume the reference point depends on the anticipation level through a function () . For any realized outcome , the DM experiences () and will be elated when )( > and disappointed when )( < . We do not address the psychological mechanisms that may form anticipation. Instead, we allow 6

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

the DM to form anticipation in many possible ways. If the DM forms her anticipation level by using her subjective probability over the possible future outcomes, then the anticipation level can be in a manner consistent with the interpretation interpreted as the certainty equivalent of the lottery of anticipation in the GM model. We also assume that this anticipation is bounded by the minimum and max respectively, possible outcome and the maximum possible outcome of a lottery, min is which is consistent with the argument by Jouini et al. (2013). If the DMs anticipation level for , = , and she also chooses the anticipation level as the mathematical expectation of the lottery the reference point when determining the elation and disappointment, i.e., () = , our model is , = + . If we also assume )( = )(, our model reduced to (1) is reduced to a Risk-Value model (Jia and Dyer 1996). In this sense, our model (1) can be considered a General Risk-Value model where the risk is measured by the anticipated experienced utility from elation and disappointment, and value is measured by the utility of anticipation. Although model (1) can be obtained by assuming some weak preference conditions as we show in the next section, it is not a simple model to study and it is more general than other models considered in the literature. A more parsimonious model that captures the tradeoff between anticipation and disappointment can be obtained by assuming a constant tradeoff factor () = 1 and a linear reference point function () = for some constant 0,1. , = )(+ (2)

In Figure 1, we show that both of model (1) and (2) are special case of the GM model. The GM model and its extension proposed by Jouini et al (2013) assume that the DM always adopts her optimal belief: the anticipation level that maximizes the total ex ante utility derived from the lottery . In contrast, we do not assume that the DM is capable of optimizing her anticipation when facing a In this way, the anticipation level in our model may reflect the DMs optimistic or lottery . 7

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

pessimistic attitude toward the future as we discuss in subsequent sections. For model (2), if both and are linear and the DMs anticipation equals the mathematical , this model reduces to the disappointment model proposed by Bell expectation of the lottery = (1985). In another special case, if the DMs preferences are not affected by anticipation, elation, or disappointment, we have = 0 and )(becomes a constant. In this case, model (2) reduces to the expected utility model. In Figure 1, we illustrate the relationships between our models (1) and (2) and other preference models in the literature.
Figure 1. The relationship of models (1) and (2) with some existing models

Gollier and Muermanns model (2010) = max )(+ ,

, ) = () () When ( and no max operation is applied to determine a

General Risk Value Model (1) , = )(+ () () When () = , () = 1 , = , When = and () =

Anticipation Disappointment Tradeoff Model (2) , = )(+ When = 0, () = 0

Risk Value Model (Jia and Dyer 1996) = + ,

, = 1, = )(and When = ;0 = )( < ;0 Disappointment Model (Bell 1985) + , =

Expected Utility Model , =

3. The preference conditions

In this section, we discuss the preference conditions that imply models (1) and (2) in section 2. We assume that there is a risky preference over the two attribute space , which is represented

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

by a von Neumann and Morgenstern utility function (, ). Since the anticipation level can be interpreted as a psychological state which reflects DMs beliefs, this setup is consistent with the premise that people not only have preferences over payoffs but also over their beliefs about payoffs as proposed by Akerlof and Dickens (1982) and with the assumption that the DM could have a preference order over the psychological states as proposed by Caplin and Leahy (2001). The set of simple lotteries defined over is denoted by and different lotteries on the payoff space are denoted , , and so on. Given these definitions, the preference condition leading to model (1) can be by stated as follows. , and any , , , Assumption 1. (Shifted Utility Independence) For any , implies that there exists a quantity (, ) such that + (, ), + (, ), . This assumption states that for lotteries resolved and paid in the second period, a DMs preference order over these lotteries is the same under different levels of anticipation if the lotteries payoffs are adjusted by a constant amount that depends on the two distinct anticipation levels. For instance, consider a gambler choosing between betting on a pair of horse races where she anticipates winning $100 for each bet. She may have the same risky preference over the two races if instead she anticipates winning $150 if all the possible payoffs are increased by an amount that depends on both $150 and $100. In a simple special case, for example, this increase could be $50=$150-$100 if preferences are linear in dollars. When the outcomes are dollars, the higher anticipation may be completely compensated by the increased payoff levels in the lotteries, and any possible disappointment and elation from each original lottery is kept the same in the transformed lottery. In general, there may also exist situations where the required adjustment quantity for the lotteries does not match the exact difference between the two levels of anticipation. However since the 9

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

adjustment is affected by the two different anticipation levels, we expect it to be a function of both and , i.e., (, ) in Assumption 1. Figure 2 provides a graphical depiction of Assumption 1.
Figure 2. Assumption 1: Shifted Utility Independence

If ,

( , ) ,

( , )

1 Then + (, ), 1

( , ) ( + (, ), ) ( + (, ), )

1 + (, ), 1

( , ) ( + (, ), )

( + (, ), )

When (, ) = 0 for any , , Assumption 1 is equivalent to the assumption that is utility independent of ( Keeney and Raiffa, 1976). Utility independence implies that, for example, the utility function over when anticipation is is an affine transformation of the utility of when anticipation is , e.g. (, ) = () + ()(, ) (Keeney and Raiffa 1976). Similarly, Assumption 1 implies that (, ) = () + ()( + (, ), ), since the preference order over , is strategically equivalent to the preference order over + (, ), . Assumption 1 leads to the additive representation of model (1) when = 0 and () is defined to be () (, 0) (0,0). Therefore, we conclude that a utility function (, ) representing risky preference over can be decomposed into model (1) under Assumption 1. Theorem 1. Assumption 1 holds if and only if the utility function (, ) can be decomposed into (1) with (0) = 0, (0) = 0, and (0) = 0. As discussed in section 2, model (2) can be obtained as a special case of model (1) by assuming () = 1 and () = for some 0,1. To state the preference assumptions for model (2), we denote (, ); (, ) as a binary lottery that results in either (, ) or (, ) with even chances. 10

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

Assumption 2. (Shifted Additive Independence) For any and , there exists (, ) 0 such that (, ); (, ) ( (, ), ); ( + (, ), ). This assumption describes a situation that may happen if a DM is uncertain about her anticipation level. Caplin and Leahy (2001) adopted a similar assumption in their anticipatory feeling or on day model. In our paper, we can consider a DM who has an even chance to obtain lottery 2 and the lottery she receives will be resolved and paid two weeks later. In this case, the DM will form her anticipation level for each lottery and begin to savor it when she learns which lottery she will receive on day 2. But, on day 1, the DM is uncertain about her anticipation level. If the DM also and respectively, the lottery she evaluates forecasts that her anticipation levels will be and for , ; , . If we assume there exist and such that , (, ) and on day 1 is , (, ), the lottery faced by the DM can be written as (, ); (, ), which is the lottery discussed in Assumption 2. Specifically, Assumption 2 assumes that the DM faces two such lotteries (, ); (, ) and (, ); (, ) . Since and , (, ) is a lower payoff associated with a higher level of anticipation and (, ) is a higher payoff associated with a lower level of anticipation. Thus, the lottery produces either a large disappointment or a large elation. The second lottery (, ); (, ) yields either a lower payoff associated with lower anticipation or higher payoff associated with higher anticipation, which produces neither high disappointment nor high elation. Put another way, the level of anticipation and the outcome received are negatively correlated for lottery 1 and positively correlated for lottery 2. If the DM is correlation seeking in the sense defined by Eeckhoudt et al. (2007) in the payoffanticipation space, she may feel like playing it safe: (, ); (, ) (, ); (, ). This situation happens when the utility function has the property of (, )/ 0 , the condition for 11

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

disappointment aversion (Gollier and Muermann, 2010). As a result, if the attractiveness of the second lottery can be reduced by some amount, it is possible that the DM is indifferent between the two lotteries. This can be achieved by spreading out the outcomes of the preferred lottery on the payoff attribute while holding the mean constant (i.e., a mean preserving spread). More formally, there may exist (, ) such that (, ); (, ) ( (, ), ); ( + (, ), ) as illustrated in Figure 3. This preference condition was proposed by He et al (2013) to axiomatize a habit formation and satiation utility function for intertemporal choice. Using Assumption 2, we conclude that the trade-off factor in model (1) is equal to 1. To obtain a linear reference point function () = so that model (1) reduces to model (2), we also need the following technical assumption.
Figure 3. Assumption 2: Shifted Additive Independence (, )

(, )

(, )

+ (, )

Assumption 3. (Linear Shifting Quantity) For any , there is a unique (, ) which depends on the difference between and , namely (, ) = ( ) 0, , satisfying the condition in Assumption 2. Under Assumptions 2 and 3, we can conclude that the utility function (, ) can be decomposed into model (2) as formally stated in Theorem 2. Theorem 2. Assumptions 2 and 3 hold if and only if the utility function (, ) can be decomposed into (2) with 0,1, (0) = 0, (0) = 0. 12

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

4. Risk Attitude
4.1 Optimism, pessimism, and risk attitude

When facing an uncertain outcome, a DMs attitude toward the future outcome may be classified into two categories, optimistic or pessimistic. When a DMs anticipation level increases, we say that she has become more optimistic which also means that she has become less pessimistic, and vice versa. Intuitively an optimistic DM believes better outcomes are more likely to occur and therefore may take more risks than a DM who is pessimistic. This positive relationship between optimism and risk seeking behavior has been modeled and tested in the literature (Misina 2005, Anderson and Galinsky 2006, Dillenberger and Rozen 2011). However, there may be situations where pessimistic people are more risk seeking; for instance, desperate people may take more risky actions (Lybbert and Barrett, 2011). In another study, Mansour et al (2008) found that pessimism is positively correlated with risk tolerance, implying that more pessimistic people are more risk seeking. In this paper, we call these two types of interaction between anticipation and risk attitude increased risk seeking behavior due to optimism (pessimism), respectively, and show that our model (2) can be used to describe both. Following convention, we define the risk attitude by comparing the expected utility of a lottery with the utility of its expectation. From this section on we denote the anticipation level as to . If E , emphasize that the anticipation level is associated with a particular lottery, > , (=, <) , we say the DM is risk seeking (neutral, averse). For a certain outcome, we assume that a DM will anticipate the outcome itself as it is the only feasible anticipation level, so that . The certainty equivalent | when the DM anticipates receiving = for a lottery | | should depend on the anticipation level, and is determined from , = , under anticipation . The risk premium for lottery is defined as ( ) = | , which also depends on the anticipation level . 13

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

In the economics literature (e.g. Bnabou and Tirole 2002, Epstein and Kopylov, 2007), optimism (pessimism) is defined by assigning higher subjective probabilities over better (worse) outcomes. If the DMs anticipation is interpreted as the certainty equivalent for the lottery based on her subjective probabilities as in GM, then the optimism and pessimism defined here are consistent with the concepts commonly used in the literature. In Proposition 1, we use , , and to denote the derivatives of , , and , respectively. The proposition states that, in our model, more optimism about a lottery (a higher level of anticipation) could either increase or decrease the risk premium of that lottery. So, our model is consistent with increased risk seeking behavior due to optimism (pessimism). when the DM Proposition 1. Under the assumptions of model (2), for a given lottery depends on anticipates , the risk premium ( ) for in the following ways:
i. If ( ) 0 , then ( ) 0. The DM exhibits increased risk seeking

behavior due to optimism .

ii. If ( ) 0 , then ( ) 0. The DM exhibits increased risk seeking

behavior due to pessimism. When the risk premium ( ) is positive, the DM is risk averse and case i describes a situation where more optimism leads to less risk aversion. Since being less risk averse implies that the DM is getting closer to risk seeking behavior, we refer to this as increased risk seeking behavior due to optimism. When ( ) is negative, the DM is risk seeking and case i describes a situation where | more optimism leads to more risk seeking as increases. The results of case ii can be interpreted in a similar way. This proposition states that whether a DM exhibits increased risk seeking behavior due to optimism or pessimism is determined by the comparison between the marginal utility of anticipation 14

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin
and the marginal anticipated experienced utility. When ( ) , the utility from the

increase in anticipation derived by the DM is larger than the utility loss from the increase in disappointment, and thus the DMs increased risk seeking behavior is due to optimism. Case i in Proposition 1 may be common for the Mega-millions lottery players discussed in the introduction. The lottery ticket buyers derive more utility from a higher anticipation than they lose from disutility due to the potential disappointment. This is consistent with the observation that many people purchase a lottery ticket as a way to acquire hope. Proposition 1 predicts that for DMs that gamble and buy lottery tickets, high levels of optimism are associated with more risk seeking behavior. This also explains why lottery companies spend money on advertisements that depict people winning the lottery to increase the anticipation level of the public such that they might become more risk seeking and buy more chances to win. Similarly, in case ii of Proposition 1 a DM worries more about the possible disappointment. If she is more pessimistic, her anticipation will be lower. Therefore, she will be less worried about the possible utility loss from a larger disappointment associated with higher anticipation. This is consistent with the empirical finding that a negative emotional state may cause people to become more risk seeking (Zhao 2006, Chuang and Lin 2007), because they value the chance of elation from receiving a better than anticipated lottery outcome that would improve their negative emotional state. Case ii cannot be explained by the EU model because shifting probability mass from the bad outcome to the good outcome will increase the expected utility of a lottery. Thus, more optimistic always implies less risk averse behavior in the EU model.
4.2 Wealth effect on risk attitude

By allowing the DM to choose the level of anticipation, our model can also capture how the DMs anticipation mediates the wealth effect on her risk attitude. For any anticipation level chosen 15

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

at wealth level , there is a unique certainty equivalent that solves the by the DM for lottery , + equation ( + , + ) = + . For a given , this certainty equivalent is a function of . In this subsection, we use ()/ to denote the derivative of with respect to wealth to emphasize this point. However, we also use the notation to indicate this function for simplicity when no derivative of the function is taken. Under model (2), the equation that defines the certainty equivalent above can be written as ( + (+ ) + + ( + ) = (+ ) + + ) (3)

We can investigate how the certainty equivalent is affected by the wealth level at different levels of anticipation by taking the derivative with respect to on both sides of (3), and solving for ()/ . ()/ =
( + ( + ) ( + ) + (1 ) + ) + ( + )

( + ) + (1 ) + ( + )

Under the standard assumptions that > 0 and > 0, the sign of ()/ is determined by the numerator. Thus, we have the following proposition about the sign of ()/. Proposition 2. When = 1 , ()0 , we have: ()/)( 0 if and only if (); when 0,1), we have: (1 ) + i. If 0, 0, 0, and implies ()/ 0. (1 ) + ii. If 0, 0, 0, and implies ()/ 0. (1 ) + iii. If 0, 0, 0, and implies ()/ 0. (1 ) + iv. If 0, 0, 0, and implies ()/ 0. Moreover, if we replace 0 with 0 and () with () , the sign of ()/ is unchanged.

16

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

When = 1 , the DM uses the anticipation as the reference point to predict the level of disappointment and the sign of ()/ is determined by the sign of . If we assume 0 , a relatively optimistic DM who anticipates becomes more risk averse with an increase in wealth, ()/ 0 ; and a relatively pessimistic DM who anticipates becomes less risk averse with an increase in wealth, ()/ 0. When 1, the sign of ()/ not only depends on the sign of but also depends (1 ) + on the sign of , as summarized by Proposition 2. These four cases demonstrate that our model has the descriptive power to capture many different ways that optimism and pessimism can mediate the wealth effect on risk aversion. For instance, in case ii of Proposition 2, (1 ) + (risk seeking). So, in this case, a DM who is and implies ) will become more risk seeking at a relatively pessimistic ( ) and risk seeking ( higher level of wealth ()/ 0 . Among these four cases, cases i and iii are of special interest, as they describe two seemingly conflicting empirical observations that people with lower levels of wealth can be either more risk averse or more risk seeking (Caballero 2010, Vieider et al 2012). implies both For case i, it is straightforward to show that and . By combining these two inequalities, we obtain (1 ). , we can conclude that a DM with an Recognizing that case i can be obtained from anticipation level lower than the certainty equivalent of the lottery and exhibiting risk averse will become more risk averse when her wealth level decreases, i.e., ()/ behavior 0. This is consistent with the observation that people with lower levels of wealth are often more risk averse than people with higher levels of wealth and are therefore less likely to participate in high risk/return investment activities, resulting in the poverty trap (Mosley and Verschoor, 2005, Yesuf 17

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

and Bluffstone 2009). is satisfied then using the result of case iii, we can Similarly, if the condition conclude that a DM with an anticipation level higher than the certainty equivalent and will become more risk seeking when her wealth level is exhibiting risk seeking behavior decreased, i.e., ()/ 0 . The result of this case matches the observation that DMs with lower levels of wealth may be more involved in gambling than DMs with higher wealth levels (Lesieur 1992). When gambling, people may anticipate favorable results; in our terms, gamblers are optimistic about the payoff of a lottery, i.e., . Thus, the certainty equivalent of a lottery for a high wealth gambler is smaller than that for a low wealth gambler, which results in relatively less gambling for high wealth DMs. Bosch-Domenech and Benach (2005) found that people with lower levels of wealth are more risk seeking than people with higher levels of wealth when facing lotteries with large absolute payoffs. This empirical finding may also be explained by case iii, since a lottery with large payoffs is more likely to induce a high anticipation leading to more risk seeking behavior for people with lower levels of wealth.
4.3 Utility of Gambling

In this subsection, we discuss a widely recognized puzzle in decision theory which is the coexistence of gambling and insurance purchasing, implying that people are simultaneously risk seeking and risk averse (Friedman and Savage 1948). This puzzling problem can be traced back to the work of von Neumann and Morgenstern who believed that gambling behavior is inconsistent with expected utility theory (von Neumann and Morgenstern 1944, p. 28 and Bleichrodt and Schmidt 2002). Only a few studies have axiomatized the utility of gambling (e.g. Diecidue, et al. 2004), and typically the utility of gambling is modeled by appending an extra utility term to the standard expected utility model or by applying different utility functions to non-degenerate and degenerate

18

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

lotteries (Fishburn 1980, Conlisk 1993 Schmidt 1998, Diecidue et al. 2004). A common weakness of these studies is that they do not provide a psychological explanation for why people would use different utility functions to evaluate risky lotteries and certain outcomes. Insurance purchasing behavior is consistent with a risk averse expected utility function, which is a special case of our model. Gambling behavior is consistent with the increased risk seeking behavior due to optimism captured by our model as discussed in subsection 4.1. When people gamble, the high anticipation associated with taking the wager can make them become more risk seeking (less risk averse) such that their risk attitude switches from risk aversion to risk seeking. To illustrate this, we consider a special case of model (2) with = 0, but a similar result can be obtained for 0. Suppose a simple lottery ticket which induces a large payoff with small probability and a zero payoff with probability 1 is available for purchase at its expected payoff . According to our model, a DM that anticipates the nonzero payoff will buy the lottery when the following condition holds )(+ )(+ (1 ()0) > )(+ )( which is equivalent to )( )( > )( )( (4)

The left hand side of (4) is the utility difference from anticipation and the right hand side is the utility difference from anticipated experienced utility. The DM may gamble because the utility difference )( )(may not be very large. However, when is large and is small, the difference )( )(could be very large. In other words, anticipating a large prize from a lottery may produce much more marginal utility than anticipating the certain payoff of the expectation of the lottery; )( )( )( )( = )( )(+ (1 ()0) . Therefore, in our model, the behavior of gambling is interpreted as a product of the high anticipation level which 19

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

outweighs the dread the DM might derive from the risk of losing. Beyond providing intuition, our model also avoids violating stochastic dominance and transitivity which is not true for most models capable of explaining this phenomenon (Fishburn 1980, Schmidt 1998, Diecidue et al 2004). Bleichrodt and Schmidt (2002) propose a context dependent model that does not violate stochastic dominance, but it does violate another desirable property: transitivity of preference (Luce 2000, MacCrimmon 1968). Stochastic dominance or transitivity is violated by these models in part because they apply different utility functions to represent the unique preference order on a set including both risky and riskless alternatives (see Bleichrodt and Schmidt 2002, Table 1). In our model, under the appropriate assumptions, the violation of both stochastic dominance and transitivity can be avoided. By definition (Bleichrodt and Schmidt 2002, Diecidue et al. 2004), a preference order satisfies , any two certain outcomes stochastic dominance if for any degenerate or non-degenerate lottery + (1 ) . Under model (2), the , , and any (0,1, if , then + (1 ) preference relation is represented by )(+ ( )( )+ ( ). Since both with functions )(and )(are monotonically increasing, we know . Compounding lottery with in will have a total ex ante utility greater than or equal to that from compounding lottery many cases, but it will depend on how a DM forms her anticipation for the compound lotteries. In Assumption 4, we describe a situation where the larger the payoff compounded with a lottery, the higher the anticipation formed by the DM. This assumption implies that when an outcome of a lottery is improved the anticipation level should not decrease, which seems to be reasonable. Assumption 4. (Consistent Compounding) A DM is said to be consistently compounding in , her anticipation levels for the compound lotteries + anticipation if for any and and + (1 ) satisfy the condition () (1 ) () . 20

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

Proposition 3 states that under Assumption 4, the preference in our model satisfies stochastic dominance when is small enough, i.e., the DM is not very sensitive to the potential disappointment. Proposition 3. Under Assumption 4, there exists , such that when 0, , + , () , () and any . (1 ) + (1 ) for any A smaller indicates that the gambler is not sensitive to disappointment, which may be true in practice. A gambler may be driven by the hope created by a large anticipated outcome. If the effect of disappointment is also strong (large ), the utility of anticipation could be reduced by the disappointment, which would further reduce the motivation for gambling. Since we observe many people repeating gambling activities, we may infer that is small for these DMs. Finally, by introducing the anticipation level in the choice set, our model can avoid the problem of intransitivity encountered by Bleichrodt and Schmidt (2002). This is apparent since the total ex ante utility (, ) is a representation of a transitive preference order defined on the two attribute space .

5. Decision making models

5.1. Portfolio selection decision

The portfolio choice problem we study involves the following choices. A decision maker has initial wealth denoted by . She selects to invest in the risky asset which has a random . Her remaining wealth is invested in a risk free asset which has a gross return . gross return The objective is to select an optimal to maximize her utility from holding both the risky and risk free assets. In the GM model, for any given level of the allocation to the risky asset, the DM selects her anticipation level so that her total ex ante utility is maximized. Thus, this optimal anticipation level is a function of the allocation to the risky asset. Then, under the assumption of optimal anticipation, the 21

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

DM optimizes the allocation to the risky asset to maximize her total ex ante utility. By solving a problem set up in this way, GM obtained the result that optimism is negatively related to allocation to the risky asset, which seems to be counterintuitive. They acknowledged that their result is somewhat surprising and that it conflicts with the results predicted by optimal expectations models (Brumnermeier and Parker 2005, Gollier 2005). Empirical studies have also confirmed that more optimistic investors tend to hold more risky assets (Manju and Robinson 2007, Balasuriya 2010, Nosic and Weber 2010). In the extended GM model (Jouini et al. 2013), the feasible domain of the anticipation level is modified to show that the GM model can be consistent with empirical studies on the relationship between optimism and investment in the risky asset. In this paper, we provide an alternative explanation and propose that the surprising result in the GM model may occur because of the optimal anticipation assumption. We acknowledge that a DM may adjust her chosen anticipation level for a lottery when she tries to increase her total ex ante utility, but this may not be a general rule that applies to all situations. The belief of a DM, which we model as the anticipation level, may be influenced by the context of the decision. For instance, in a bear market, no matter how optimistic an investor may be, she may not be able to form an optimistic anticipation level for money invested in stocks. Moreover, as we discussed above, the GM model assumes that a DM can forecast how the allocation decision will influence the total ex ante utility through the optimal anticipation. In our development we relax this demanding requirement that the DM will be able to optimize her anticipation level intentionally when facing such a portfolio selection problem. We allow the anticipation level to be influenced by contextual factors and set up the portfolio decision model as follows. Influenced by the economic environment, the DM forms anticipation for the random risky return, which is bounded by the minimum and maximum possible outcomes of 22

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

, i.e, , max . Then, her anticipated total wealth is given by ( ) + min = + ( ). The utility of anticipation is (+ ( ))and the anticipated experienced utility is ( ) + ( ( ) + = (1 ) + ). Utilizing these components in (2), the DM optimizes the allocation of her wealth to risky asset by solving the following problem ( max () = (+ ( ))+ (1 ) + ) (5)

If we assume that both and are concave functions, () is also a concave function of as the sum of concave functions is still concave. Under these assumptions we can obtain the following result. Proposition 4. The optimal investment in the risky asset in (5) is > (=, < 0) if and only if
()( ) ()

. > (=, <)( )

We expect a DM who invests in the financial market to anticipate that the risky asset return exceeds the risk free return > 0; otherwise the investor would not choose to invest in the risky asset. In this case, we can rewrite the optimal investment condition in Proposition 4 as > 0 if and only if
() ()

>

, is positive and Since the risk premium of the risky asset,

, is always negative. In 0,1, when the anticipated return is low, i.e. when < this case,
() ()

>

always holds as and are both positive. Recall that the

anticipation level can be interpreted as a certainty equivalent of the lottery based on subjective when the subjective probabilities probabilities. Thus, under the assumption of concave , < become close to the objective probabilities. The above results imply that if the DM has beliefs that are close to the objective probabilities, she will always invest in the risky asset. , If the anticipated return is relatively high, e.g. > the marginal utility ratio
() ()

is always smaller than one. If

is always larger than one, then > 0 and the DM always 23

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

can be explained as the result of invests in the risky asset. In this case, the inequality > optimistic beliefs that deviate significantly from objective probabilities. Thus, this result implies that when a DM is very optimistic, she will invest in the risky asset only if the marginal utility she derives from anticipation is large enough to counter the potential disappointment. Now, we treat the anticipated return as a parameter and analyze how it influences the optimal investment level which we will denote as ( ). Proposition 5. There exists a such that ) ). This proposition states that when the marginal utility from anticipation is large enough at the
optimal investment level, i.e., ( + ( > ) ), the DM will invest more given a higher

0 if and only if ( + (

anticipation level. This is a very intuitive result. The DM will only increase the investment in a risky asset when the marginal utility she derives from anticipation is large enough to offset the utility loss from the potential disappointment. Besides being consistent with the empirical finding that more optimistic DMs will invest more in the risky asset, our model can also be employed to explain the equity premium puzzle, which can be described as follows: In order to explain the much higher available returns of risky assets (stocks) compared to riskless assets (bonds), investors must have extremely high levels of risk aversion. GM noted that the literature on optimal expectations (Brunnermeier and Parker 2005, Gollier 2005) assumes the DM always optimizes her beliefs and selects a risker portfolio, reinforcing the equity premium puzzle, while their model implies that optimism of a DM is negatively related to the investment in a risky asset, reducing the equity premium puzzle. However, empirical studies suggest that a more optimistic DM will invest more in the risky asset (Manju and Robinson 2007, Balasuriya 2010, Nosic and Weber 2010). Thus, although the GM model is consistent with the equity premium 24

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

puzzle, it conflicts with both our intuition and the empirical finding that optimism should induce more risk taking behavior and more investment in the risky asset. Our model can explain the equity premium puzzle without conflicting with the finding that optimism leads to increased investment in the risky asset. As shown by Proposition 4, our model can
be used to represent preferences with either ( )/ 0 or ( )/ 0 depending on

the functional form used to model utility from anticipation. To be consistent with the empirical finding on the relationship between optimism and risk taking, we should assume preferences exhibit ( )/ 0. To explain the equity premium puzzle, we propose that if DMs in the financial market are generally pessimistic, i.e., anticipate a lower level of , our model implies a decrease in the demand for the risky asset, which increases the equity premium. Finally, we should emphasize that this descriptive flexibility comes from the relaxation of the optimal anticipation (belief) assumed by other models in the literature (Brunnermeier and Parker 2005, Gollier 2005, Gollier and Muermann 2010).
5.2. Optimal advertising decision

In this section, we explore the optimal advertising level for a marketer facing a consumer who trades off the utility of anticipation and the utility from anticipated disappointment consistent with model (2). We will model the consumers decision to purchase or not to purchase a single unit of a product. Further, we assume that the customer will not know the quality of the product until after it is defined on a bounded payoff set purchased and model the predicted quality as a simple lottery of quality measures for the product. However, we assume that the consumer has some knowledge about the probability distribution of this uncertain quality level. Before purchasing the , max . Under the product, the consumer anticipates the quality of the product min assumption of model (2), the total ex ante utility derived from purchasing one unit of this product is

25

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

given by ( ) + ( ) while the total ex ante utility from not purchasing the product is 0. Following the convention in the economics literature (e.g. Shogren 1994), we assume the consumer has additive utility over wealth and her consumption of the product, i.e., (, )( = )+ (). The consumers willingness to pay (( )) is determined by solving equation (6) ( ) + + ( ( ) ) = () where ( )is the utility function over her wealth. For this problem, we can show that the maximum willingness to pay is obtained at an interior , max under some standard assumptions. level of the anticipation in the domain min
> 0, 0, 0, 0 , Proposition 6. Under some standard assumptions,

(6)

min > 0 and max max < 0 , there exists an min

interior optimal anticipation ) is maximized. min , max such that (

This proposition states that if a consumer derives utility from both anticipation and the anticipated experienced utility, the optimal level to anticipate should be neither too high nor too low. Now, we consider a seller who is attempting to sell a new product to a group of consumers, each with a concave willingness to pay function ( ) due to the tradeoff between high anticipation and high disappointment. To model the heterogeneity of the consumers in the market, we assume the willingness to pay of each customer is given by ( ) = ( ) + , where is a mean zero random variable with cumulative density function that captures the uniqueness of a consumers preferences. If the seller sets the price of the product at , the consumer will buy the product if ( ) + . Therefore, the response function is given by (, ) = 1 ( ) , which depends on both the price and anticipation . Further, the seller can influence the anticipated quality of the product through her advertising effort, , measured in dollars. We assume that the consumers anticipated quality of the product is positively related to the advertising effort 26

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

)/, and is given by the linear relationship = + , where 0, with = (max which is the effort level that will cause the consumer to anticipate the highest possible quality. In this linear relationship, is the base anticipation level of the consumer when no advertising effort is exerted; and is the increase in anticipation produced by one marginal unit of advertising effort. This assumption of a positive relationship between the anticipated quality of the product and the advertising effort has been documented by Deighton (1984). Kirmani and Wright (1989) also verified that the perceived advertising expense has a positive relationship with consumers expectation of product quality in a laboratory setting. Goering (1985) and others have argued that increasing the expected quality of a product can increase the demand for the product and that advertising is a way to increase the consumers quality expectation and therefore product sales (Simon and Arndt 1980, Bagwell 2005, Erdem et al. 2008). However, as we show in Proposition 7, the response function in our context is maximized at an appropriate level of advertising effort < , because a high anticipation level of product quality produced by advertising effort can also induce high anticipated disappointment, decreasing the consumers willingness to pay. In other words, advertising can raise a consumers expectation so high that she would prefer not to purchase the product for fear of being disappointed with its actual quality. Proposition 7. For fixed price , the response function is maximized at an advertising effort level =

, when < (>) , (, ) > (<)0.

Finally, we consider a problem where a seller determines the optimal advertising effort for a given price to maximize her profit (). Each unit of product is assumed to have a constant cost of production and the optimal effort is the solution to (7) max () = ( )1 (+ ) (7)

The first order condition of (7) is ( ) (+ ) ( + ) 1 = 0 2. Since 27

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attains its maximum at =

, we know that the optimal advertising effort to maximize the

total profit is < , so that ( + ) = ( ) ( + ) >0. Therefore, we have the following proposition. Proposition 8. For fixed price , the profit is maximized at an advertising effort level that is lower than the effort level maximizing the willingness to pay, < . This result implies that sellers of a product should not always seek to increase consumers willingness to pay. When willingness to pay is above ( + ) , the marginal cost of the advertising effect the unit cost in our model outweighs the marginal contribution to the profit produced by the increase in willingness to pay, which further reduces the total profit. Again, increasing the anticipated quality level of a product via advertising can reduce sales when customers grow concerned that their high expectations cannot be satisfied and choose to abstain from a purchase.

6. Conclusion
In this paper, we propose preference conditions for a decision making model which incorporates both the utility of anticipation hope and dread and the anticipated experienced utility elation and disappointment in a decision making process. This model captures optimism and pessimism by allowing the DM to choose to anticipate any outcome of a lottery being evaluated. The level of anticipation serves two roles in our model: it is the source of the utility of anticipation in the period before the lottery is resolved as well as the reference point used to form elation and disappointment after the lottery is resolved. We show that our model can account for how optimism could influence both the DMs risk attitude as well as the wealth effect on that risk attitude. This optimism can explain the coexistence of gambling and the purchasing of insurance without violating stochastic dominance and transitivity. Finally, we discuss the applications of this model in both finance and marketing contexts. In a simple 28

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setting with one risky and one risk-free asset, we show that our model can capture the widely observed behavior that an investors optimism is positively correlated with her investment level in the risky asset. It also provides an explanation for the equity premium puzzle that is consistent with this empirical finding. In a marketing context, we show that using advertising to increase the customers anticipation level of product quality with the intent to increase her willingness to pay does not always increase the demand for a product. This result conflicts with the intuition that product demand is increasing with advertising, and should be studied in more detail with controlled experiments.

Notes:
1. See Yahoo news: http://news.yahoo.com/blogs/sideshow/mega-millions-hits-record-640million-jackpot-160916556.html 2. We also assume the second order condition is satisfied:
()

0.

References:
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Bnabou, R., J. Tirole, 2002. Self-Confidence and Personal Motivation. The Quarterly Journal of Economics. 117(3) 871-915. Bell, D. E. 1985 Disappointment in Decision Making Under Uncertainty, Operations Research. 33(1) 1-27. Bosch-Domenech, A., J.S. Benach, 2005. Ready to Take Risks? Experimental Evidence on Risk Aversion and Attraction. Working paper: http://www.crei.cat/research/opuscles/op16ang.pdf Bleichrodt, H., U. Schmidt. 2002 A Context-Dependent Model of the Gambling Effect. Management Science. 48(6) 802-812 Brunnermeier, M. K., J. A. Parker. 2005 Optimal expectations. American Economic Review 95(4) 1092-1118. Brunnermeier, M. K., C. Gollier. J. A. Parker. 2007 Optimal beliefs, asset prices, and the preference for skewed returns. American Economic Review. 97(2) 159-165. Caballero, G.A. 2010. Risk Preferences Under Extreme Poverty: A Field Experiment. SSRN working paper. http://ssrn.com/abstract=1720983 Carroll, P. J., K. Sweeny, J. A. Shepperd. 2006. Forsaking Optimism. Review of General Psychology. 10(1) 56-73. Caplin, A., J. Leahy. 2001. Psychological Expected Utility Theory and Anticipatory Feelings. The Quarterly Journal of Economics, 116(1) 55-79. Conlisk, J. 1993. The Utility of Gambling. Journal of Risk and Uncertainty. 6(3) 255-275. Chew, S. H., J. L. Ho. 1994. Hope: An Empirical Study of Attitude Toward the Timing of Uncertainty Resolution. Journal of Risk and Uncertainty. 8(3) 267-88.

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He, Y., J. S. Dyer, J. C. Butler. 2013 On the Axiomatization of Satiation and Habit Formation Utility Function. Operations Research, forthcoming Jia, J., J. S. Dyer, J. Butler 2001 Generalized Disappointment Models. Journal of Risk and Uncertainty. 22(1) 59-78 Jouini, E., P. Karehnke, C. Napp. 2013. On Portfolio Choice with Savoring and Disappointment. Management Science, forthcoming. Available at SSRN: http://ssrn.com/abstract=2291836 Kirmani, A., P. Wright. 1989. Money talks: Perceived advertising expense and expected product quality. Journal of Consumer Research. 16, 344353. Loewenstein, G. 1987. Anticipation and the Valuation of Delayed Consumption. The Economic Journal. 97(387) 666-684. Loewenstein, G., & Linville, P. (1986). Expectation formation and the timing of outcomes: A cognitive strategy for balancing the conicting incentives for savoring success and avoiding disappointment. Unpublished manuscript Loomes, G., R. Sugden. 1986. Disappointment and Dynamic Consistency in Choice under Uncertainty. Review of Economic Studies. 53(2) 271-282. Lybbert, T. J., C. B. Barrett, 2011. Risk-Taking Behavior In The Presence Of Nonconvex Asset Dynamics. Economic Inquiry, Western Economic Association International. 49(4) 982-988. Lesieur, H. R., 1992 Compulsive Gambling. Society 29(4) 43-50. Manju, P., D. T. Robinson, 2007. Optimism and Economic Choice, Journal of Financial Economics. 86(1) 71-99. Mansour, B. S., E. Jouini, J. M. Marin, C. Napp, C. Robert. 2008. Are Risk Averse Agents More Optimistic? A Bayesian Estimation Approach. Journal of Applied Econometrics. 32(6) 843860.

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http://EconPapers.repec.org/RePEc:zbw:wzbrad:spii2012401 Yesuf, M., R. A. Bluffstone, 2009 Poverty, Risk Aversion, and Path Dependence in Low-Income Countries: Experimental Evidence from Ethiopia. American Journal of Agricultural Economics. 91(4) 1022-1037. 33

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Zhao, J. 2006. The Effects of Induced Positive and Negative Emotions on Risky Decision Making. Talk presented at the 28th Annual Psychological Society of Ireland Student Congress, Maynooth, Ireland. http://www.princeton.edu/~jiayingz/pdfs/BAThesis06.pdf

34

Appendix for Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making
Ying He, James S. Dyer, John C. Butler* Department of Information, Risk, and Operations Management Department of Finance* McCombs School of Business, The University of Texas at Austin, Austin, Texas 78712 ying.he08irom@utexas.edu, j.dyer@mccombs.utexas.edu, butlerjc@mccombs.utexas.edu Theorem 1. Assumptions 1 holds if and only if the utility function (, ) can be decomposed into , = )(+ () () with (0) = 0, (0) = 0, and (0) = 0. Proof: Sufficiency: by Assumption 1, we have (, ) = () + ()( + (, ), ) = () + ()( + (, ) (0,0) + (0,0), ) , () , )(: = ( + (0,0), 0) since (, ) and ( + (, ), ) are strategically equivalent to each other. Let = 0 and define () (, 0) (0,0) , )(: = and in (, ) = () + ()( + (, ) (0,0) + (0,0), ), we have (1). By definition of (), we have (0) = 0. Since utility function is unique up to affine transformation, we can rescale the utility function (, ) such that ((0,0), 0) = 0 and (0) = 0. Thus, we have (0) = 0 and (0) = 0. , and any , if , , , from model (1) we have, Necessity: for any , = )(+ () () )(+ () () = , () () . For any , since , () > 0 , this which implies inequality is equivalent to + () () () )(+ () + () () () )(+ () + (, ), + (, ), Define (, ) = () (), so we have Theorem 2. Assumptions 2 and 3 hold if and only if the utility function (, ) can be decomposed into , = )(+ with 0,1, (0) = 0, (0) = 0. Proof: Sufficiency: Assumption 2 implies 1 (, ) + (, ) = ( (, ), ) + (2) (1)

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

( + (, ), ) . Let = 0, = 0 and rescale (, ) such that (0,0) = 0 , we have (, ) = ( (, 0), 0) + ((, 0), ) . Define () (, 0) , (( )(, 0), ) , and () ( (), 0), we have (, ) = )(+ (). Now, we prove () is linear. According to Assumption 2, for any and , we have (, ); (, ) ( (, ), ); ( + (, ), ) . Expressing this condition in term of (, ), we have (, ) + (, ) = ( (, ), ) + ( + (, ), ) Let = + (, ), the above equation is equivalent to (, ) (, ) = ( (, ), ) ( (, ), ) Similarly, we have for (, ) (, ) = ( (, ), ) ( (, ), ) ( (, ), ) ( (, ), ) = ( (, ) (, ), ) ( (, ) (, ), ) Thus, we have (, ) (, ) = ( (, ), ) ( (, ), ) = ( (, ) (, ), ) ( (, ) (, ), ) According to Assumption 3, this (, ) is unique which is a function depends on the difference between and , namely (, ) = ( ) is unique. Thus, from the uniqueness of this (, ), we have ( ) = ( ) + ( ) By setting = 0 in above equation, we have () () = ( ) . Let = , we have () + () = ( + ), which is a Cauchy functional equation (Aczl 2006). The solution to this equation is () = for . Because Assumption 3 states that ( ) 0, for , we have 0,1. Since we defined () (, 0) = (), we have () = . Finally, from (0,0) = 0, (( )(, 0), ), and () ( (), 0), it is easy to conclude that (0) = 0 and (0) = 0. Necessity: given (, ) = )(+ ( ), we have (, ) + (, ) = )(+ ( ) + )(+ ( ) = )(+ (+ ( ) ) + )(+ (+ ( ) ) = ( + ( ), ) + ( + ( ), ) Define (, ): = ( ) , since 0,1 , we know there exits (, ) = ( )

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

0, such that Assumption 2 holds. This also proves (, ) 0, in Assumption 3. Finally, to prove the uniqueness of (, ) stated in Assumption 3, suppose there exists another (, ) = + (, ) such that (, ) + (, ) = ( (, ), ) + ( + (, ), ) = ( (, ), ) + ( + + (, ), ) Let (, ) = , we have ( (, ), ) ( (, ), ) = ( + + (, ), ) ( + (, ), ) = ( + + (, ) (, ), ) ( + (, ) (, ), ) = ( + , ) (, ) = (, ) ( , ) Since , are arbitrary, , are also arbitrary. Denote utility function (, ) by (). The last equation above is equivalent to ( + ) ( )( = ) ( ) for any , . Taking derivative with respect to , we have ( ) ( ) = 0. Then, taking derivative with respect to , we have ( ) = 0, which implies (( = ), ) is a linear function in . This violates the law of diminishing marginal utility. Thus, the (, ) is unique. when the DM anticipates Proposition 1. Under the assumptions of model (2), for a given lottery depends on , the risk premium ( ) for in the following ways:
i. If ( ) 0 , then ( ) 0. The DM exhibits increased risk seeking

behavior due to optimism .

ii. If ( ) 0 , then ( ) 0. The DM exhibits increased risk seeking

behavior due to pessimism.

| Proof: According to the definition ( ) = , ( ) 0( 0) if and only if |

| | , 0( 0) . By definition and model (2), , = = ( ) +

| | , we have + (1 ) = ( ) + . Thus, we have:

| | + (1 ) (1 )

It is easy to verify that

| = ( )

0( 0) if and only if ( ) 0( 0).

Proposition 2. When = 1, ()0, we have: ()/)( 0 if and only if (); when 0,1), we have: 3

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

i.

(1 ) + If 0, 0, 0, and implies ()/ 0.

(1 ) + ii. If 0, 0, 0, and implies ()/ 0. (1 ) + iii. If 0, 0, 0, and implies ()/ 0. (1 ) + iv. If 0, 0, 0, and implies ()/ 0. Moreover, if we replace 0 with 0 and () with () , the sign of ()/ is unchanged. Proof: From (3) in the text, we know
()

()() ()

()() () ()

When = 1, since > 0, the sign of

is determined by the comparison between and .

When 0,1). We only show case i here. The other cases can be obtained by following the same idea. When 0, 0, 0 , from 0 , by Jensens inequality, we can conclude
( + ( + (1 ) + + ) + ) . From 0 , implies + (1 ) (1 ) + (1 ). Thus, we have ( + + ) + ( + ) ( + + ) + ( + ) 0 Moreover, from 0 and , we have ( + ( ) + ). Therefore, we can

conclude the numerator of the above equation is positive. Since we also assume > 0 and > 0, we conclude that ()/ 0 in this case. Proposition 3. Under Assumption 4, there exists , such that when 0, , + (1 , () , () and any . ) + (1 ) for any is the common part for both compounding lotteries considered here, Proof: Since the lottery we simply denote the anticipation by ( )indicating that the anticipation depends on , which is the . Stochastic dominance requires that when : certain payoff compounded with , () = () + () + (1 ) () + (1 ) () = + (1 ) , () () + () + (1 ) Under the assumption of consistent compounding in anticipation, we have () () for any , namely ()( = )/ > 0, stochastic dominance is satisfied by our model when 4

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

, ()/ > 0, which is equivalent to the condition + (1 ) () ( > )0 () ( )+ ()1 () (1 ) Without loss of generality, we assume that marginal utility is bounded, i.e., , . Then, let solves the following equation () ( )+ 1 () = (1 ) () = () ( )+ >0 + (1 ) ()

when ( > )0, ( > )0, and ( > )0. Then, we have for any 0, , () ( )+ ()1 () > () ( )+ 1 () () () = (1 ) (( > )1 ) which implies that the stochastic dominance holds. Proposition 4. The optimal investment in the risky asset in (5) is > (=, < 0) if and only if
()( ) ()

. > (=, <)( )

Proof: Taking derivative with respect to in (5), ( max () = (+ ( ))+ (1 ) + ) we have:

()

(5)

( = ( ( + ( ()) )+ ) (1 ) +

( ) . Since we assume and are concave, () is also concave. Thus,

()

> (=, <)0 is equivalent to > (=, < 0), which leads to the result.
0 if and only if ( + ( ) ).

Proposition 5. There exist a such that

Proof : When no derivative of ( ) is taken, we keep using for simplicity. By

differentiating the first order condition for (5) with respect to , we can solve for

as follows

) ( ( ) ( ) ( ) ( ) ) ( )( ( )

( where we define two functions ( ) = (1 ) + ) and ( ) = + ( )to simplify the expression above. Under the assumption that < 0 and < 0 , the

denominator of the right hand side is negative. Therefore, a negative numerator is equivalent to a

He, Dyer, and Butler: Hope, Dread, Disappointment, and Elation from Anticipation in Decision Making The University of Texas at Austin

positive

. A negative numerator is equivalent to the condition:

( ) ( ) + ( ) < ( ) + ( )( ) ( Define = ) ( ) + ( ) ( )( ) , we

can get the result in the proposition.

> 0, 0, 0, 0, min Proposition 6. Under some standard assumptions,

min > 0 and max max < 0, there exists an interior optimal
anticipation ) is maximized. min , max such that (

Proof: Note that the consumers willingness to pay is a function of her anticipation for this one unit of the product. Differentiating both sides of (6) with respect to , ( ) + + ( ( ) ) = () we find ( ) =

(6)

min > 0, and . When > 0 , min

max < 0 , max

> 0 and max < 0 . If we we have min

take the derivative of (6) with respect to twice, we can solve for ( ) =
( )

Under the assumption of 0, 0, and 0, we can verify that ( ) 0. Thus, we

can conclude the result stated in the proposition. Proposition 7. For fixed price , the response function is maximized at an advertising effort level =

, when < (>) , (, ) > (<)0.

Proof: By taking the derivative of (, ) = 1 (+ ) with respect to , we have (, ) = (+ ) ( + ) . Since > 0, we know from the proof of
Proposition 6 that when + < , ( + ) > 0 , and (, ) > 0 , sales are increasing with ; when + > , ( + ) < 0 and (, ) < 0, sales are decreasing in .