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American Economic Review: Vol. 102 No. 6 (October 2012)

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Modeling the Change of Paradigm: Non-Bayesian Reactions to Unexpected News

Article Citation

Ortoleva, Pietro. 2012. "Modeling the Change of Paradigm: Non-Bayesian Reactions to Unexpected News." American Economic Review, 102(6): 2410-36.

DOI: 10.1257/aer.102.6.2410

Abstract

Bayes' rule has two well-known limitations: 1) it does not model the reaction to zero-probability events; 2) a sizable empirical evidence documents systematic violations of it. We characterize axiomatically an alternative updating rule, the Hypothesis Testing model. According to it, the agent follows Bayes' rule if she receives information to which she assigned a probability above a threshold. Otherwise, she looks at a prior over priors, updates it using Bayes' rule for second-order priors, and chooses the prior to which the updated prior over priors assigns the highest likelihood. We also present an application to equilibrium refinement in game theory. (JEL D11, D81, D83)

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Authors

Ortoleva, Pietro (CA Institute of Technology)

JEL Classifications

D11: Consumer Economics: Theory
D81: Criteria for Decision-Making under Risk and Uncertainty
D83: Search; Learning; Information and Knowledge; Communication; Belief


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