Stopping Behaviors of Naive and Non-Committed Sophisticated Agents When They Distort Probability
36 Pages Posted: 13 Sep 2017
Date Written: September 11, 2017
We consider the problem of stopping a diffusion process with a payoff functional involving probability distortion. The problem is inherently time-inconsistent as the level of distortion of a same event changes over time. We study stopping decisions of naive agents who reoptimize continuously in time, as well as equilibrium strategies of sophisticated agents who anticipate but lack control over their future selves' behaviors. When the state process is one dimensional and the payoff functional satisfies some regularity conditions, we prove that any equilibrium can be obtained as a fixed point of an operator. This operator represents strategic reasoning that takes the future selves' behaviors into account. In particular, we show how such strategic reasoning may turn a naive agent into a sophisticated one. Finally, when the diffusion process is a geometric Brownian motion we derive stopping strategies of these two types of agent for various parameter specifications of the problem, illustrating rich behaviors beyond the extreme ones such as "never-stopping" or "never-starting".
Keywords: optimal stopping, probability distortion, time inconsistency, naive and sophisticated agents, equilibrium stopping law
JEL Classification: G11, I12
Suggested Citation: Suggested Citation