Twentieth International Conference on Environmental, Cultural, Economic & Social Sustainability

Abstract

We consider an agent who posits a set of probabilistic models for the payoff-relevant outcomes. The agent has a prior over this set but fears the actual model is omitted and hedges against this possibility. The concern for misspecification is endogenous: If a model explains the previous observations well, the concern attenuates. We show that different static preferences under uncertainty (subjective expected utility, maxmin, robust control) arise in the long run, depending on how quickly the agent becomes unsatisfied with unexplained evidence and whether they are misspecified. The misspecification concern’s endogeneity naturally induces behavior cycles, and we characterize the limit action frequency. This model is consistent with the empirical evidence on monetary policy cycles and choices in the face of complex tax schedules. Finally, we axiomatize in terms of observable choices this decision criterion and how quickly the agent adjusts their misspecification concern.