Decision Under Risk 1

Question 1

What is the “hard core” of economics?

Answer 1

The notion of rationality, people behave as if they maximise a well defined utility function.

Question 2

What is a problem with this “hard core” of economics?

Answer 2

It can neither be verified or tested as it provides no testable predictions.

Question 3

Why are there no testable predictions?

Answer 3

As people have very different utility functions, so it can be very difficult to call anything irrational?

Question 4

What is then added to this “hard core”, in order to allow us to make testable predictions?

Answer 4

We can add additional assumptions to this “hard core”, in what is called the “protective belt”.

Question 5

If a model explains behaviour, are the assumptions relevant or not?

Answer 5

The assumptions are not relevant.

Question 6

But if we shouldn’t evaluate a theory by its assumptions, what should we evaluate it by?

Answer 6

• Congruence with reality
• Generality
• Tractability
• Parsimony

Question 7

What does tractability mean?

Answer 7

Means making a theory easy, as more complex theories are more difficult to apply and test.

Question 8

What does parsimony mean?

Answer 8

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”.

Question 9

What are behavioural economics methods?

Answer 9

• 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.

Question 10

What is required for any true economic experiment?

Answer 10

Players must play for real money- as there has to be a real incentive.

Question 11

In the real world is ceteris paribus ever met?

Answer 11

No

Question 12

What do econometricians use to bridge the gap between the theoretical and real worlds?

Answer 12

An error term (ε)

Question 13

Name a disadvantage of economic experiments.

Answer 13

• 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.

Question 14

What is the standard model of risky choice?

Answer 14

Expected Utility Theory (EUT)

Question 15

Will a risk averse person always reject a fair prospect?

Answer 15

Yes

Question 16

What is the expected value of a fair prospect under EUT?

Answer 16

0

Question 17

What will a risk neutral person do when presented with a fair gamble?

Answer 17

They will be indifferent towards accepting or rejeccting.

Question 18

What is the shape of a risk averse persons utility function?

Answer 18

Concave (ie bends round closer to the 12 o’clock of a 45 degree line)

Question 19

Which common example of a type of person contradicts the idea that we are born with a set risk parameter?

Answer 19

The kind of person who purchases house insurance but also gambles on sports.

Question 20

What are the axioms of EUT?

Answer 20

• Completeness
• Transitivity
• Continuity
• Independence

Question 21

What does the completeness axiom mean?

Answer 21

For all lotteries (A,B) either A is preferred to B, B is preferred to A or the consumer is indifferent.

Question 22

What does the transitivity axiom mean?

Answer 22

If A>B and B>C then A>C

Question 23

What does the continuity axiom mean?

Answer 23

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.

Question 24

What does the independence axiom mean?

Answer 24

Adding a common consequence should not modify a persons preferences.

Question 25

Which axiom does the Allais Paradox violate?

Answer 25

The Independence Axiom

Question 26

Why is the Reflection Paradox an issue?

Answer 26

Because it makes it appear as if people have different risk preferences over positive and negative outcomes.

Question 27

What’s a feature of the Isolation Effect?

Answer 27

Where people isolate the gamble from their initial income.

Question 28

What’s a feature of the Event Splitting Effect?

Answer 28

Where a person choose a different lottery to the split problem than they choose when the problem is combined.

Question 29

What is Stochastic Dominance?

Answer 29

When one gamble is unambiguously superior to another. According to EUT people will never choose a gamble which is stochastically dominated by another.