Decision making under impending regime shifts

Matthias Seifert, Canan Ulu, Sreyaa Guha

Research output: Contribution to journalArticlepeer-review

2 Citations (Scopus)

Abstract

In environments with impending regime shifts, previous research studies probability judgments of decision makers (DMs) regarding a regime shift and finds evidence for the system neglect hypothesis: In unstable environments with precise signals, DMs exhibit relatively more underreaction in their probability judgments, and in stable environments with noisy signals, they exhibit relatively more overreaction. In the present paper we focus on pricing decisions and study how risk attitudes, as well as probability judgments regarding a regime shift, affect these decisions. We develop a model that integrates prospect theory with the system neglect hypothesis and compare changes in empirical pricing decisions to those of a Bayesian risk-neutral agent. We find a pattern of under- and overreaction in pricing decisions that mimics the system neglect hypothesis in probability judgments only when the DM’s prior probability of a regime shift is low; the system neglect pattern vanishes when the DM’s prior probability of a regime shift is high. We argue that in the case of low priors, changes in risk attitude in reaction to signals indicative of a regime shift amplify system neglect in probability judgments. In the case of high priors, on the other hand, changes in risk attitude dampen the effect of system neglect. We test our model predictions in experimental insurance markets and offer various extensions to check for the robustness of our findings. Finally, we discuss implications for managerial practice in organizational contexts that are characterized by continuous change.
Original languageEnglish
Pages (from-to)6165-6180
JournalManagement Science
Volume69
Issue number10
Early online date12 Jan 2023
DOIs
Publication statusPublished - Oct 2023

Keywords

  • Regime shift detection
  • System neglect
  • Prospect theory
  • Risk preferences
  • Experimental markets

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