(1) Expected Utility Theorie

Question 1

Risky World - Definition

Answer 1

• Likelihood and implications of each outcome are known

- We know how actions affect probabilities of outcomes

Question 2

Uncertain World - Definition

Answer 2

• No full knowledge about the probabilities and exact implications of the outcomes

Question 3

What is the St. Petersburg Paradox

Answer 3

Game with an infinite Expected Value (EV) but a finite Expected Utility (EU) due to the diminishing marginal utility

Question 4

Risk Aversion - Definition

Answer 4

• EU(g) < EV(g)
• CE < EV(g)
• RP > 0
• concave utility function

Question 5

Risk Neutrality - Definition

Answer 5

• EU(g) = EV(g)
• CE = EV(g)
• RP = 0
• linear utility function

Question 6

Risk Proneness - Definition

Answer 6

• EU(g) > EV(g)
• CE > EV(g)
• RP < 0
• convex utility function

Question 7

What is the von Neumann/ Morgenstern expected utility function and what does it require?

Answer 7

• u(Safe) = u(x2)
• u(gamble) = u(0,5[x1] + 0,5[x2]) = 0,5 u(x1) + 0,5 u(x2)
• requires that the independence axiom is fulfilled

Question 8

Independence Axiom - Definition

Answer 8

If g(1) > g(2) for any a and gamble g3:
a[g1] + (1-a)*[g3] > a[g2] + (1-a)*[g3]
(Third gamble does not matter)

Question 9

Common Consequence Effect (Allais Paradox) - Definition

Answer 9

Choice problem that shows an inconsistency between actual observed choices and the predictions of the expected utility theory.

Explanation: Violations are mistakes of participants

Question 10

Prospect Theory - Definition

Answer 10

• Fundamental modification of the EUT Theory
• Outcomes are evaluated against reference point
• Assumes loss aversion (losses have higher impact)
• Switchover in risk attitudes at reference point (losses: risk proneness, gains: risk averse)
• Assumes a transformation in probabilities (distorted perception of probabilities)
• Is compatible with some behaviour that is not in line with EUT

Question 11

Expected Utility Theory - Definition

Answer 11

• Person want to maximize their expected utility
• Utility depends on the risk preferences of a person (risk averse, neutral or prone)
• Monetary values != utility level
• Is used in economics to evaluate outcomes against each other
• Is used for decision making under uncertainty