Asset pricing in a Lucas fruit-tree economy with the best and worst in mind

Abstract

This paper studies a Lucas (1978) fruit-tree economy under the assumption that the agents are Choquet expected utility (CEU) rather than standard expected utility decision makers. More specifically, the agents’ non-additive beliefs about the economy’s dividend payment process are modeled as neo-additive capacities so that the agents’ decision behaviour emphasizes the best, respectively worst, possible economic scenarios. In contrast to existing models of Lucas-type economies with ambiguity averse agents (Epstein and Wang, 1994), which ensure dynamic consistency through heavy restrictions on admissible ambiguity attitudes gives up dynamic consistency to the effect that quite general ambiguity attitudes become admissible. As the main formal result I establish the existence of a unique stationary equilibrium price function for this CEU Lucas economy. As the main economic insight I obtain that a representative agent who is rather preoccupied with the worst case scenario gives rise to a lower risk-free rate and a higher equity premium than predicted by the original expected utility Lucas economy. This difference is the greater the more surprising the economic information is that the agent receives.