3- Choice under Incomplete Information Flashcards

1
Q

What is the difference between choice under uncertainty and risk?

A

Choice under risk is when the probabilities of the outcomes are meaningful and known

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2
Q

What 2 elements summarise the decision set under uncertainty?

A

-Action space (A); all possible choices for agent
-States of the world (S); all possible environments

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3
Q

How do you construct a payoff table?

A

Matrix of all the states of the world on top row and action space on left column

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4
Q

What is the maximin criterion?

A

The best choice is the one with the greatest minimum utility payoff

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5
Q

How do you construct a utility table?

A

Same as payoff table but each cell is the product of the utility of the action and state of world

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6
Q

What is the maximax criterion?

A

The best choice is the one with the greatest maximum utility payoff

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7
Q

What is the minimax-risk criterion?

A

The best choice is the one with the lowest maximum regret aka Regret Aversion

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8
Q

What is the definition of regret?

A

Utility of (preferable) alternative action given a specific state

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9
Q

What are 2 main critiques of the maximin criterion?

A

-Does not take into account payoffs/utilities that are not the worst
-Focuses exclusively on worst outcome (even if probability would be small)

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10
Q

What is the definition of expected value?

A

The sum of probability-weighted outcomes

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11
Q

How can you determine whether insurance is a good deal?

A

Establish a lifetime for product usage, calculate money spent on insurance in that period, establish breakeven probability of downside scenario

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12
Q

What is the shape of a risk averse utility function?

A

Concave

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13
Q

What is the shape of a risk prone/affine utility function?

A

Convex

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14
Q

What is the shape of a risk neutral utility function?

A

Linear

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15
Q

What is the Certainty Equivalent?

A

The amount of money such that an individual is indifferent between taking the lottery and taking the
money

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16
Q

What is the Certainty Equivalent equation?

A

L is the number CE that satisfies the equation u(CE) = EU(L) i.e. expected lottery utility equals certain utility

17
Q

What are the 3 properties of the value function in prospect theory?

A

-Ranges over changes in endowment (not about total endowments)
-Steeper for losses than for gains
-Convex for losses and concave for gains

18
Q

How can you prove loss aversion from 2 value functions one for gains one for losses?

A

Get the first derivative for each domain, show the absolute value of the loss domain gradient is greater

19
Q

How can you prove risk-aversion/affinity for the value function of either the loss or gain domain?

A

Take the second derivative of the value function and show whether it’s convex or concave

20
Q

How do you calculate expected value of an upside and downside scenario for a prospect theory value function?

A

Sub in each scenario to respective value function, and multiply the probabilities on the outside

21
Q

What are the 2 ways individuals can bundle gains/losses?

A

-Integrate; evaluating net value of gains/losses
-Segregate; evaluating each gain/loss separately

22
Q

Why does Bundling violate rational choice theory?

A

Because utility functions are defined over total endowments/final outcomes

23
Q

How do you integrate gains/losses mathematically using value functions?

A

Sum the gains and losses for a single value of x and substitute into value function

24
Q

How do you segregate gains/losses mathematically using value functions?

A

Put each outcome into its own value function and sum them

25
What is the silver lining effect?
Individuals are more satisfied if gains are segregated (due to risk-aversion in the gain frame)
26
What is the cancellation effect?
Individuals are less dissatisfied if losses are integrated (due to risk-proneness in the loss frame)
27
What is the Sure-Thing principle?
Rational decisions based on Expected Utility Theory should not be affected by sure things
28
What does the Allais paradox show?
The sure-thing principle is systematically and predictably violated in real world decision making
29
What is the Certainty Effect?
Decision-maker frequently overweight outcomes that are certain
30
Define Ambiguity Aversion
If lotteries involve both, known (risky) and unknown (ambiguous) probabilities, subjects tend to avoid ambiguous outcomes
31
What are the 3 main properties of the probability weighting function (π) in prospect theory?
-Perceived probability is increasing in underlying probability -Yes and no certainties are understood as such -Perception is greater/less as probability approaches 0/1