Decision-making under risk & uncertainty (Week 4)

Question 1

What are the managerial concepts of risk?

Answer 1

1. Loss or harm
   - Larger loss = more risky
2. Control
   - Less control over outcomes = more risky
3. Unknown
   - Less familiar = more risky

Question 2

What are some observations about our risk attitudes?

Answer 2

1. Research shows little correlation across domains
2. If you feel good about an activity, you see higher benefits & lower costs i.e. perceive risk & benefit as -vely correlated

Question 3

What are some examples of domains of risk?

Answer 3

Financial, ethical, health/safety, recreation, social

Question 4

What is risk?

Answer 4

Risk = Variance of probability distribution of outcomes

Question 5

What are some decision rules?

Answer 5

1. Dominance
2. Maximax
3. Maximin
4. Maximise Expected Value (EV)

Question 6

What is the dominance decision rule?

Answer 6

Choosing Option A over Option B

Outcomes of A are at least as good as B for all possible states of the world

Question 7

What is the maximax decision rule?

Answer 7

Heuristic-based rule

Choose option that maximises the max possible outcome

Question 8

What is the maximin decision rule?

Answer 8

Heuristic-based rule

Choose option that maximises the min possible outcome

Question 9

What is the expected value decision rule?

Answer 9

Choose option that has the highest sum over possible outcomes of probability x dollars

Question 10

What is Bernouli’s (1738) notion of expected utility?

Answer 10

People make choices that maximise their (expected) utility

Principle of diminishing marginal utility

Question 11

What is the principle of diminishing marginal utility?

Answer 11

Each additional dollar added to wealth brings less utility

Question 12

According to normative perspective: expected utility, how do people make choices?

Answer 12

People make choices that maximise expected utility

EU = Sum of probability * utility of receiving $x

Question 13

According to descriptive perspective: prospect theory, how do people make choices?

Answer 13

People make choices that maximise value of prospect

Value of prospect = Decision weight of probability * Value of receiving $x

Question 14

What does prospect theory suggest about probability?

Answer 14

People overestimate low probability and underestimate high probability

Question 15

What is the fourfold pattern of risk attitudes?

Answer 15

Risk-seeking (low p gain)
Risk-aversion (low p loss)
Risk-aversion (high p gain)
Risk-seeking (high p loss)

Question 16

What are the three aspects of prospect theory?

Answer 16

1. Reference dependence
2. Diminishing sensitivity
3. Loss aversion

Question 17

What is reference dependence in prospect theory?

Answer 17

Ppl are sensitive to losses & gains relative to their reference state (status quo)

Question 18

What is diminishing sensitivity in prospect theory?

Answer 18

Ppl are less and less sensitive to each additional dollar gained/lost

Question 19

What is loss aversion in prospect theory?

Answer 19

Losses loom larger than gains, i.e. value function is steeper for losses than gains

Question 20

What are the consequences of the value function?

Answer 20

1. Loss aversion

Question 21

What is the endowment effect?

Answer 21

Once ppl take possession of an object, they demand MORE to give it up than they would have paid to acquire

Question 22

What are the explanations for the endowment effect?

Answer 22

1. Loss aversion
   - We evaluate gains much less strongly than losses of equal magnitude
2. Mere ownership effect
   - Subjective feeling that the object is yours