Ignorance and Indifference : Decision-Making in the Lab and in the Market

Economic agents live in a perpetually changing environment, with new gambles and new economic regimes regularly arising. Such dynamics can be handled by incremental and frequently restarted Bayesian learning. The ensuing scarcity of information about the parameters of the environment is tackled with the priors that recognize the prevailing ignorance. Thus, in response to uncertainty about the underlying parameters, agents overweight the chances of less probable events. Empirically, these mechanics allow to rationalize and reproduce both the Allais paradox/prospect theory’s probability transformations identified in laboratory experiments, as well as the equity premium/risk-free rate levels observed in financial markets