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EC2A3 > 6. Consumer choice revisited – decision-making with risk and insurance. > Flashcards

6. Consumer choice revisited – decision-making with risk and insurance. Flashcards

1
Q

Defintion of risk

A

Facing an uncertain but quantifiable future

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2
Q

Definition of uncertainity

A

Facing an uncertain and unquantifiable future

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3
Q

The difference between risk and uncertainity

A
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4
Q

What is a lottery

A
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5
Q

What happens when we control for probability in a lottery?

A

Moral hazard

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6
Q

Example of lotteries

A
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7
Q

The expected utility of a lottery
* Equation

A
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8
Q
A

Depends on preference and inital level of wealth
People are more concerned about the downside risk than upside

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9
Q
A
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10
Q

What are outcomes and probabilities often based on?

A
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11
Q

Is expected utility cardinal or ordinal?

A
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12
Q

What are the different risk attitudes

A
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13
Q

What are the utility functions associated with different risk attitudes?

A
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14
Q
A
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15
Q

What is a certainty equivalence

A

Fixed amount of money that an individual would be indifferent between the lottery and that amount
Certain amount that makes you indifferent between CE and lottery

What fixed amount of money would give you the same outcome as the lottery. A higher CE means the lottery is worth more.

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16
Q

Slide 14 question

A
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17
Q

What is the relationship between the certainity equivalent for:
* Risk averse
* Risk loving
* Risk neutral

A

Slide 15

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18
Q

Risk averse utility curve with a lottery utility line
Jensen’s inequality

A

Slide 16-17

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19
Q

Risk loving utility curve with a lottery utility line

A
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20
Q

Risk neutral utility curve with a lottery utility line

A
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21
Q

Jensen’s utility

A

For any concave function U(W) (risk averse individual):
The utility of the expected value of a lottery is always higher than the expected utility from playing the lottery

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22
Q

Risk premium for risk averse utility curve and lottery

A
23
Q
A
24
Q

What are the ways to measure risk aversion:

A
25
Q

Concave utility example
* (Arrow-Pratt) coefficient of absolute risk aversion
* (Arrow-Pratt) coefficient of relative risk aversion

A
26
Q
A
27
Q
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28
Q

Which is better

A
29
Q

Which is better

A
30
Q

What is a Mean preserving spread and how does it look on a utility curve

A
31
Q

Decision making with risk

A
32
Q
A
33
Q

What happens to the EU theory when there are modest stakes?

A
34
Q

(Kahneman, 2011)
How does he describe overconfidence?

A
35
Q

Why should we have limits on the concave utility curve?

A
36
Q
A
37
Q

The impact of overconfidence on probabilities
E.g. 2008 financial crisis

A
38
Q
A
39
Q
A
40
Q
A
41
Q

What is framing and loss aversion?

A
42
Q

Prospect theory

A
43
Q
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44
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45
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46
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47
Q
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48
Q

Stetzka and Winter (2021)
What phenomenon are the authors trying to explain?

A
  • The expected return of gambling is negative so why do people carry on to gamble?
  • Some may say they love risk
  • An alternative reason is that it could be rational if gamblers diversify risk
49
Q

Stetzka and Winter (2021)
How do the authors define full rationality, bounded rationality and irrationality?

A
  • Full rationality: well-organised, stable and transitive preferences. Correct calculations and Complete self control so they always choose the best option
  • ** Bounded rationality**: Relaxation of at least one of the assumptions behind full rationality. (E.g. Mistakes in calculations). still enage with the process of optimisation
    • Irrationality: Anything that falls short of rationality (E.g. Pathological gamblers believe they will win big money). Believe they have made a rational choice when they have not
50
Q

Stetzka and Winter (2021)
What attitude to risk would gamblers have to have in order for their actions to be fully rational, assuming they have purely financial motivations?

A
  • Risk love:
  • Expect negative retuns and variances across bets.
51
Q

Stetzka and Winter (2021)
Is this a plausible explanation for the observed phenomenon?

A
  • If they were doing it for financial purposes, they would prefer roulette wager, as it is less random then horse betting.
  • But people play horse betting, which is random despite the fact that it is more rational to do a roulette wager.
  • Non financial components add to utility and make it rational for you to bet with negative expected returns.
52
Q

Stetzka and Winter (2021)
What other motivations might explain gambling behaviour assuming fully rational gamblers?

A
  • The money won brings utility as the gambler did not have to work for it
  • Fun
  • Anticipating a win may bring utility
  • Adds to the utility of a game if you are betting on it.
53
Q

Stetzka and Winter (2021)
Provide examples of ways in which gamblers may display bounded rationality

A
  • Heuristics: Avoidance of deliberation costs
  • Anchoring effects in which people’s expectations are biased due to the first price they encounter
  • Rules for gambling allow for people to take money away from food consumption
  • Gamblers fallacy: Irrational behaviour in which they believe that prior outcomes will affect future outcomes, despite the fact that they are not correlated.
  • Hot hand effect: Constantly winning means that you will continue to win
  • Problem gamblers especially believe that they control the game
  • Overestimating small probabilities
54
Q

Stetzka and Winter (2021) How prevalent is problem gambling and why is it irrational? What might explain problem gambling?

A
  • Gamblers tend to ditch their plans and continue to gamble in the face of losses. Loss of control. Want to stimulate the brain for the potential excitement of winning?
  • Lower levels of education
  • Emotion-focused coping mechanism
  • Gender
  • Below-average social status

EC2A3 (10 decks)

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