Inter-Temporal Preference for Flexibility and Risky Choice

Abstract

We derive an inter-temporal theory of changing tastes from the normative primitives defined in Sagi (1998). Using a notion of time consistency we establish several interesting results: (i) the set bounding agents' potential tastes shrinks (weakly) with time, (ii) non-linear induced preferences can be accommodated, thereby suggesting a way to resolve the problem raised by Kreps and Porteus (1979), (iii) our theory reduces to that of Kreps and Porteus (1978) when tastes do not change, (iv) agents can have a `utility for flexibility' similar to the theory by Kreps (1979) and Nehring (1999), although the representation need not be additive. The last observation can be seen as a normative basis for accommodating Knightian uncertainty about changing tastes. We also specifically model consumption-investment behavior and find the following: (i) agents will be immune to manipulation only if they assign a premium to flexibility, (ii) such agents will continue to trade contingent claims in complete markets subsequent to the initial trading of endowments, (iii) a Bayesian rational expectations equilibrium can be constructed in which there is no arbitrage and agents have changing tastes. In particular, our last result shows that both higher trading volume and greater price volatility can be expected when agents behave according to our axioms.

JEL Classification: D50, D81, D99, G11, G12