Decision-making under risk & uncertainty (Week 4) Flashcards
What are the managerial concepts of risk?
- Loss or harm
- Larger loss = more risky - Control
- Less control over outcomes = more risky - Unknown
- Less familiar = more risky
What are some observations about our risk attitudes?
- Research shows little correlation across domains
- If you feel good about an activity, you see higher benefits & lower costs i.e. perceive risk & benefit as -vely correlated
What are some examples of domains of risk?
Financial, ethical, health/safety, recreation, social
What is risk?
Risk = Variance of probability distribution of outcomes
What are some decision rules?
- Dominance
- Maximax
- Maximin
- Maximise Expected Value (EV)
What is the dominance decision rule?
Choosing Option A over Option B
Outcomes of A are at least as good as B for all possible states of the world
What is the maximax decision rule?
Heuristic-based rule
Choose option that maximises the max possible outcome
What is the maximin decision rule?
Heuristic-based rule
Choose option that maximises the min possible outcome
What is the expected value decision rule?
Choose option that has the highest sum over possible outcomes of probability x dollars
What is Bernouli’s (1738) notion of expected utility?
People make choices that maximise their (expected) utility
Principle of diminishing marginal utility
What is the principle of diminishing marginal utility?
Each additional dollar added to wealth brings less utility
According to normative perspective: expected utility, how do people make choices?
People make choices that maximise expected utility
EU = Sum of probability * utility of receiving $x
According to descriptive perspective: prospect theory, how do people make choices?
People make choices that maximise value of prospect
Value of prospect = Decision weight of probability * Value of receiving $x
What does prospect theory suggest about probability?
People overestimate low probability and underestimate high probability
What is the fourfold pattern of risk attitudes?
Risk-seeking (low p gain)
Risk-aversion (low p loss)
Risk-aversion (high p gain)
Risk-seeking (high p loss)
What are the three aspects of prospect theory?
- Reference dependence
- Diminishing sensitivity
- Loss aversion
What is reference dependence in prospect theory?
Ppl are sensitive to losses & gains relative to their reference state (status quo)
What is diminishing sensitivity in prospect theory?
Ppl are less and less sensitive to each additional dollar gained/lost
What is loss aversion in prospect theory?
Losses loom larger than gains, i.e. value function is steeper for losses than gains
What are the consequences of the value function?
- Loss aversion
What is the endowment effect?
Once ppl take possession of an object, they demand MORE to give it up than they would have paid to acquire
What are the explanations for the endowment effect?
- Loss aversion
- We evaluate gains much less strongly than losses of equal magnitude - Mere ownership effect
- Subjective feeling that the object is yours
