Decision making under risk and uncertainty (Week 1)

Question 1

Theory prediction - Decision making under risk and uncertainty

Answer 1

Theory predicts choices depend on attitudes to risk (utility functions), outcomes and probabilities

Question 2

What are the three utility functions which influence people’s decisions under risk?

Answer 2

Risk averse, risk neutral and risk lover

Question 3

Utility Function for Risk averse

Answer 3

Risk averse utility functions - diminishing marignal utility
- E.g., U($x) = x^1/2

Question 4

Utility function for risk loving

Answer 4

Risk loving utility functions - increasing marginal utility
- E.g., U($x) = x^2

Question 5

Utility function for risk neutral

Answer 5

Risk neutral utility functions - constant marginal utility
- E.g., U($x) = x

Question 6

What does Expected utility theory imply?

Answer 6

Expected utility theory implies that people’s choices depend only on their utility functions (their attitudes to risk) the probabilities and the outcomes and they ignore irrelevant/common outcomes/consequences

Question 7

What is the common consequence?

Answer 7

If you are given two options for bundles of fruit
Option 1: 40% apples 40% pears 20% grapes
Option 2: 30% apples 50% pears 20% grapes

Then 20% grapes will be the common consequence

Question 8

The psuedo experiments explained

Answer 8

• The pseudo experiments are similar to some famous experiments that have been carried out in research
• They are pairs of experiments that are very similar but they differ in the way they are framed or have a different common (irrelevant) consequence
• These difference lead people to make different choices
• The evidence suggests limitations of expected utility theory
• According to the theory, people’s choices should not be affected by the way questions are framed or by common (irrelevant) consequences - choices depend only on the probabilities and outcomes.
• If you frame your question as how many people will die or how many people will survive you will have different choices. The expected monetary outcomes are the loss but people systematically choose the gamble in the die scenario and choose certainty in the ‘save’ scenario

Question 9

Why does expected utility theory not always capture the way people actually behave

Answer 9

• Expected utility theory does not always capture the way people actually behave
• Loss aversion, timing, common consequences
  -People do not always learn from their mistakes
  Behavioural change and nudge theory:
• Recognises seemingly irrational behaviour
• Factors that influence decision making e.g., framing of the question, value of common consequences, sunk cost fallacy