Decision under risk 1 Flashcards
Hard core and protective belt of behavioural econ
-Hard core believe of microeconomics is the belief agents act rationally and aim to maximise a well defined utility function. Makes no testable predictions.
-The protective belt refers to additional assumptions placed onto the hard core assumptions which lead to testable predictions. Protective belt assumptions protect the hard core from scrutiny.
Independence axiom of EUT
Independence axiom (cc axiom) states for all lotteries/prospects A, B containing a common consequence. A change in the CC cannot change a persons preference between A and B.
-As the CC is in both lotteries it shouldn’t therefore affect individuals comparison of the lotteries.
-CC is included in both lotteries/prospects.
Stochastic dominane axiom of EUT
-Stochastic dominance, one lottery which is ‘better’ can be created by shifting prob from bad outcome to bad outcome. A prospect is unambiously better therefore dominates.
-For any two lotties A B where A stochastically dominates B, A is always preffered to B.
Allais paradox
-Allais paradox leads to a viilation of the independece axiom, meaning the common consequence affects individuals comparison of prospects.
-EUT shows if a person prefers one gamble over another, they should also prefer a mixture of these gambles in the same proportion but allias paradox violates this.
-Shows violations in indepence axiom
Reflection effect
Eg) Two stages of prospect choosing
1A: (£4000,0.8 ; £0,0.2)
1B: (£3000,1)
2A: (-£4000,0.8 ; £0,0.2)
2B:(-£3000,1)
-Most people choose 1b and 2a, displaying risk aversion in one stage (gains) and risk loving in another stage (typically with losses).
-Reflection effect shows individuals appear to have different preferences over risk over gains and losses. Risk preferences not stable, context dependent.
Isolation effect
EG)Stage1:
£1000 +
1A: (£1000, 0.5; £0, 0.5)
1B: (£500,1)
Stage 2:
£2000 +
2A: (-£1000, 0.5; £0, 0.5)
2B: (-£500,1)
-Most common choice is 1b then 2a, displaying risk aversion in A but risk loving in B but EU is equal therefore isolate from initial income.
-The isolation effect shows people isolate the gamble/prospect from initial income.
Violations of stochastic dominance
-Violations occur when individuals choose prospects that do not stochastically dominate the other prospect.
-Eg if A unambiousaly the better outcome compared to b(can be created by shifting prob in other outcome from bad to good) but B is chosen to A – > violation.
What do the paradoxes in EUT show
-How the theory of expected utility, rational theory is violated/ real life scenarios don’t always mimic the models behavior.
Where does behavioural econ fit in econmoics.
-Modern behaviouarl economics contains the hard core rationality assumptions therefore not a radical depareture from neoclassical economics. However it operates at the ‘protective belt’ assumptions placed onto the hard core to reduce scrutiny.
Advantages of experiments
-As in the real world cetrius parabus is never met a random error term is used to bridge the gap between theoretical models and the real world. Therefore more accurate predictions.
-Econometric experiment/test isnt a test for theory but a joint test of theory and error term
Disadvantages of eperiemnts (hawthorne effect)
-Hawthorn effect, a disadvantage of experiments, occurs when subjects improve or modift an aspect of their behavior in response to the fact they are getting measured/studied, not in response to an aspect of the experiment.
-Therefore what people do in labatories may not be a represenation of real life behaviour.
