Decision Under Risk 1 Flashcards
What is the “hard core” of economics?
The notion of rationality, people behave as if they maximise a well defined utility function.
What is a problem with this “hard core” of economics?
It can neither be verified or tested as it provides no testable predictions.
Why are there no testable predictions?
As people have very different utility functions, so it can be very difficult to call anything irrational?
What is then added to this “hard core”, in order to allow us to make testable predictions?
We can add additional assumptions to this “hard core”, in what is called the “protective belt”.
If a model explains behaviour, are the assumptions relevant or not?
The assumptions are not relevant.
But if we shouldn’t evaluate a theory by its assumptions, what should we evaluate it by?
- Congruence with reality
- Generality
- Tractability
- Parsimony
What does tractability mean?
Means making a theory easy, as more complex theories are more difficult to apply and test.
What does parsimony mean?
Try to make the explanations in as little assumptions as possible- Occam’s razor- “what can be done in fewer explanations in done in vain with more”.
What are behavioural economics methods?
- Use models with better psychological assumptions in order to make a theory more convergent with reality.
- Experiments
- Neuro-imaging to scan people’s brains as they make economic decisions.
What is required for any true economic experiment?
Players must play for real money- as there has to be a real incentive.
In the real world is ceteris paribus ever met?
No
What do econometricians use to bridge the gap between the theoretical and real worlds?
An error term (ε)
Name a disadvantage of economic experiments.
- The Hawthorne effect- people being studied often modify their behaviour just because they know that they are being studied.
- Therefore some economists believe that experiments of people in a lab may not be representative of their behaviour in the real world.
What is the standard model of risky choice?
Expected Utility Theory (EUT)
Will a risk averse person always reject a fair prospect?
Yes
What is the expected value of a fair prospect under EUT?
0
What will a risk neutral person do when presented with a fair gamble?
They will be indifferent towards accepting or rejeccting.
What is the shape of a risk averse persons utility function?
Concave (ie bends round closer to the 12 o’clock of a 45 degree line)
Which common example of a type of person contradicts the idea that we are born with a set risk parameter?
The kind of person who purchases house insurance but also gambles on sports.
What are the axioms of EUT?
- Completeness
- Transitivity
- Continuity
- Independence
What does the completeness axiom mean?
For all lotteries (A,B) either A is preferred to B, B is preferred to A or the consumer is indifferent.
What does the transitivity axiom mean?
If A>B and B>C then A>C
What does the continuity axiom mean?
For all lotteries (A,B,C), there exists a unique probability p such that the lottery pA+(1-p)C is indifferent to lottery B.
What does the independence axiom mean?
Adding a common consequence should not modify a persons preferences.
Which axiom does the Allais Paradox violate?
The Independence Axiom
Why is the Reflection Paradox an issue?
Because it makes it appear as if people have different risk preferences over positive and negative outcomes.
What’s a feature of the Isolation Effect?
Where people isolate the gamble from their initial income.
What’s a feature of the Event Splitting Effect?
Where a person choose a different lottery to the split problem than they choose when the problem is combined.
What is Stochastic Dominance?
When one gamble is unambiguously superior to another. According to EUT people will never choose a gamble which is stochastically dominated by another.
