How do economic agents assess the relative merits of alternative choices?

There are many questions to be resolved in choosing alternatives, such as the length of planning horizons, the degrees of precisions with which the factors or variables are known or estimated, and the degree to which agents are able to allow for externalities caused by other agents' decisions.

To partially answer this important question, we assume that economic agents calculate or estimate present values of the consequences of their alternative choices, and choose the ones with the largest present value. Agents do this by calculating the discounted present values of alternative streams of profits, uti­lities, or whatever other “things” contribute to their benefits. Agents' decision­making problems are complex, partly because alternative streams of revenues, utilities, and the likes are only incompletely and imperfectly known or estimated. Their future choice sets may also be altered by past positions or by choices they or others have made. They may also be unaware of aggregate effects of choices made by others. Agents usually are not able to allow for the externalities completely. The utility or cost of individual decisions is often affected by these aggregate effects.

Actually, such calculations of present values are by no means straightforward, being affected at least by the same set of difficulties. In our approach, these externalities are reflected in the specifications of the transition rates that govern the behavior of a group of agents. In economic applications of jump Markov processes, transition rates may be endogenously determined, as we illustrate later. Here, we describe the way value functions are calculated by individual agents. Search-theoretic examples in later chapters show how the differences in the calculated present values enter the transition rates in dynamic search models.

6.1