2. Risky Decisions Flashcards
In standard theory what is a risky decision?
It can be construed as a choice among prospects
What is the difference between risk and uncertainty?
In risk situations all probabilities and consequences of prospects are known to the decision maker. This isn’t the case in uncertain situations
Expected utility theory
Individuals choose among prospects to maximise V(q)=sum of (PiU(xi))
Since utility is subjective, what does expected utility depend on?
The shape of an individual’s utility function
Concave= risk aversion
Linear= risk neutral
Convex= risk seeking
What does linear in probabilities mean?
To construct the expected utility of a prospect, the utility of each consequence is weighted by its probability
What are examples of classic violations of EUT?
The Allais Examples
•common consequence effect
•common ratio effect
Are violations of EUT thought to be mistakes?
Economists debate over whether these are mistakes or not
When will people be more sensitive to changes in probability in terms of their weighting of utility?
Near the extremes of probabilities
How do subjective attitudes of chance explain the Allais example?
If there are overweighting of small probabilities then the attractiveness of B decreases. There is no corresponding effect in C or D assuming people combine probabilities of the same outcome
The decision weight condition
The ratio of weightings for each probability
What does editing in prospect theory involve?
Mainly simplifications of info such as rounding payoffs and probabilities
What are rank dependent versions of prospect theory?
They depend on both the objective probability of the consequence and it’s rank in the set of consequences
What is disappointment theory?
The idea that individuals anticipate potential disappointment and are motivated to avoid it
How does disappointment theory aim to explain Allais example?
Individuals are much more upset if they pick B and get 0 so they avoid it
