1 - Expected Utility Theory Flashcards
Describe the expected utility theory
The decision maker chooses the prospect with the highest expected utility. Since people avoid risk, it is necessary to compensate them for assuming it, and the degree to which they must be compensated depends on their risk aversion.
People are assumed to have rational preferences and to make independent decisions based on all relevant information.
What is the certainty equivalent?
The wealth level that leads the decision-maker to be indifferent between a particular prospect and a certain wealth level. The certainty equivalent is the amount of wealth that, if received with certainty, would give the decision-maker the same level of utility as the expected utility of a risky prospect, according to their utility function.
What are examples of observations violating the expected utility theory?
An individual can be both risk-averse or risk-seeking depending on the choice of prospects (Allias paradox).
When we present a choice problem to a person, a change in frame can lead to a change in decision. This is a violation of expected utility theory, which rests on the assumption that people should have consistent choices, regardless of presentation.
Describe a risk averse individual according to expected utility theory
Risk averse people:
- Have diminishing marginal utility of wealth (concave utility function)
- Certainty equivalent less than expected return
- Buy insurance policies (and don’t buy lottery tickets)
Describe a risk-seeking individual according to expected utility theory
Risk-seekers:
- Have increasing marginal utility of wealth (convex utility function)
- Certainty equivalent greater than expected return
- Buy lottery tickets (and shun insurance)
