Choice Flashcards
Axioms of Utility theory
Completeness
Transitivity
Continuity
Probabilistic Consistency
Independence
Completeness
If a data set contains (x,y) then x>y, y>x, or x~y
Transitivity
If x>y, y>z, then x>z
Continuity
If x>y>z then there will be a combination of xz in which (xz)~y
Probabilistic consistency
An individual will be indifferent between x and y, if x and y produce the same outcome with the same probability
Independence
If there are some states that lead to the same outcome under all decisions then it will not effect the individuals decision making
Endowment
The initial allocation of economic resources before any economic decisions
x≥y
x is at least as good as y: weak preference
x>y
x is strictly preferred to y: strong preference
x~y
Individual is indifference between x and y
Aspiration treadmill
Process where increasing endowments lead to rising aspirations
Status quo bias
Tendency to prefer existing states of affairs
Reference point
A point in which individuals view economic decisions
Factors effecting reference point
Level of endowments
Social comparisons
Adjustment time to wins or losses
Expectations
Opportunity cost
The value of the next best alternative forgone because of a particular choice: Implicit cost
Explicit cost
Monetary cost of an action
Sunk cost fallacy
The continuing investment in an action, even if it does not maximise utility, due to the high previous investment of said action
Expansion condition
If x>y then the addition of z would not lead to the consumer picking y from the data set (x,y,z)
Menu dependence
The evaluation and relations between choices is dependant on the alternatives offered
Decoy effect
The addition of an alternative product in order to change consumers actions
Compromise effect
Tendency to choose an alternative that represents a compromise
Extremeness aversion
Tendency to avoid extreme options
Endowment effect
The greater utility given to items which an individual already owns
Framing effect
A change in an individuals actions from the change in how a situation is presented
Risk
Outcome is unknown but probability of each event is known
Uncertainty
Probability is unknown
Maximin rule
Best worst possible outcome
Maximax rule
Best best possible outcome
Hurwics rule
Weighted average of all possible outcomes
Laplace rule
Assigns same probability to each outcome
Minimax regret rule
Minimise possible regret
St Petersburg paradox
The expected value of a game in which a player can win 2^n monetary value will be infinite
Von Neumann-Morgenstern utilities
Utility numbers that describe an individuals preference over risky outcomes. Only unique up to positive affine transformation
Utility Calculations
EV(x)=pw1+(1-p)w2
EUi(x)=Upw1+U(1-p)w2
Ui(CEi(x))=EUi(x)
RPi(x)=EV(x)-CEi(x)
Risk premium
+ : risk adverse
- : risk loving
0 : risk neutral
Outcome space
Set of all possible individual outcomes
The Equiprobability rule
Equal probability of each of the outcomes
The Everything rule
The probability of the entire outcome space is equal to one
The not rule
The probability that an event will not occur P(¬a)=1-P(a)
The And rule
If A and B are independent of each other, than the probability of A and B is the multiplied probability of each
P(A&B)=P(A)*P(B)
Conjunction fallacy
A fallacy of judgement that occurs when a combination of two or more attributes is judged to be more probable or likely than one of them on its own
Independence
The probability of two events are not related
P(A|B)=P(A)
P(B|A)=P(B)
P(A&B)=P(A)*P(B): The and rule
Dependence, Conditional Probability
P(A&B)=P(A)*P(B|A)
Mutually exclusive
P(A&B)=0
Bayes’ Theorem
P(A|B)=P(B|A)*P(A)/P(B)
The Mere exposure effect
The tendency for individuals to form a liking or disliking for things merely because they are familiar with the thing
Assumptions of Exponential discounting model
Preferences are time consistent: Hold the same 𝛿 when evaluating options
Preferences do not vary with stakes: 𝛿 is the same regardless of the value of the utility
Preferences are not reference-dependent: same 𝛿 regardless of whether consumption is in gains or losses
Hyperbolic discounting
Time inconsistency: Preferences change with time, individuals are impulse and lack self-control
Types of time-inconsistent individuals
Naïve type:
They are unaware of their self-control problems. They make decisions based on the inaccurate assumption that their preferences are time-consistent
Sophisticated type:
They are aware of their self-control problems. They make decisions based on accurate predictions of their future
Commitment device
Restricting one’s choice set or menu in order to prevent unwanted behaviour
Disjunction Fallacy
The tendency to underestimate the probability of a disjunction of events (A or B occurring)
Planning Fallacy
Tendency for individuals or organisations to overestimate the probability of conjunction in relation to stages, components, or time
Confirmation bias
The tendency for people to seek out information which agrees with their point of view
Representativeness Heuristic
The tendency to estimate the probability that some outcome was the result of a given process by reference to the degree to which the outcome is representative of that process
Base rate fallacy
The tendency for individuals to ignore the base rate probability
Regret aversion
The tendency for individuals to behave in a way to minimize anticipated regret
Allais paradox
Shows individuals do not behave in line with expected utility theory
Attraction effect
The addition of a decoy to make another alternative look more attractive to individuals
Loss aversion
The tendency for individuals for individuals to have a greater change in utility for a loss than an equal size gain
Value Function
Measures the change in value relative to a reference point
Find utility in each time period and weight it for the value function and whether it occurred
Exponential discounting model
Delta Model
Assumes time consistency
Hyperbolic discounting
Beta-Delta Model
Individuals lack self-control
Gambler’s Fallacy
The tendency for individuals to see two independence events as related
Overconfidence
Tendency for individuals to over-estimate their own abilities
Availability Bias
The tendency for individuals to place importance on information that comes easy to mind
Maximin criterion
Greatest minimum payoff
Maximax criterion
Greatest maximum payoff
Minimax-risk criterion
Lowest maximum risk or regret
Mental Accounting
The tendency for individuals to view the spending of money differently depending on how it is spent
Integrated Outcomes
When outcomes are combined
Integrate losses
Segregate Outcomes
When outcomes are separate
Segregate Gains
Sure-thing principle
Individuals who decide they would take a certain action in case of an outcome whom would also do the same in neglection of the outcome, should do the same action is they knew nothing of the event
Certainty effect
The tendency for individuals to predict disproportionally better outcomes than the probability
Probability Weighting
Individuals assign a higher weight on low-probability events whilst assigning low weights on moderate or high-probability events
