3. Decision-Making Under Risk

Question 1

Expected Value

Answer 1

Probability-weighted average of the payoffs associated with all possible outcomes.
- E(X) = Pr1X1 + Pr2X2 … etc
- Choices with the same expected value may involve different degrees of volatility (measured by variance or s.d.)

Question 2

Expected Utility Theory

Answer 2

Individuals aim to maximise expected utility
- E(u) = Pr1.u(X1) .. etc -> sum of the utilities associated with all possible outcomes, weighted by prob. of occurance.
- Accept the gamble if EU of gamble is ^ than certain utility if not accepted.

Question 3

Risk Averse Person

Answer 3

Dislikes risks, preference of certainty over uncertainty with same expected value
Graph:
- Utility Function is concave = decreasing marginal utility of income
- MU of income measures change in TU as income increases = measure of the slope

Question 4

Risk Loving Person

Answer 4

Prefers uncertainty with the same expected income over a certain one.
Graph:
- Convex = increasing MU of income

Question 5

Risk Neutral Person

Answer 5

Indifferent to a fair gamble
Graph:
- Straight line = constant MU of income

Question 6

Demand for Insurance

Answer 6

Insurance Markets provide 1 mechanisms for individuals to share risks = reducing individual exposure to risk

Question 7

Reservation Price for Insurance

Answer 7

Max. someone would pay for insurance as a consumer

Question 8

Certainty Equivalent Value (of a gamble)

Answer 8

Sum of money for which an individual is indifferent between receiving that sum or taking a gamble

Question 9

Risk Premium

Answer 9

Difference between expected value of a lottery and a payoff of a sure thing that would make the individual indifferent between the lottery and the sure thing

Question 10

Loss Aversion

Answer 10

Individuals treat gains and losses differently in their decision-making
- more sensitive to losses > a gain of the same amount

Question 11

Framing effects

Answer 11

Individuals are influenced by the way the options are framed

Question 12

Reference Dependence

Answer 12

Individuals evaluate alternatives without using UF but instead VF that is defined over changes in wealth
- individuals are sensitive to changes in wealth > absolute wealth

Question 13

Diminishing Sensitivity

Answer 13

Value function is concave in gains and convex in losses

Question 14

The Allais Paradox

Answer 14

Goes against the Expected Utility Theory
- people favour certainty over probabilistic outcomes even if its inconsistent with decision making