Decision Under Risk Flashcards
What are the hardcore assumptions of neoclassical economics?
It is the belief that people are rational: They behave as if they maximise a well defined utility function.
On its own terms, this belief can be neither falsified or verified as it makes no testable predictions
What is the protective belt of neoclassical economics?
Additional assumptions economists impose on the utility function e.g. monotonicity, continuity, completeness.
These additional assumptions lead to testable predictions.
However, this can protect the hardcore from scrutiny - empirical irregularities can be attributed to failings of PB
What are the psychological assumptions of neoclassical economic agents?
Costlessly process info Are Bayesian probability operators Discount time exponentially Are governed purely by selfish concerns Maximise expected utility
What is the defence of standard assumptions in behavioral economics?
Economic theory should not be judged on the realism of its assumptions, but on how well the theories explain behaviour - e.g. business owners dont know their MC curves but behave in a way ‘as if’ they do
If predictions of the theory hold, it is ‘as if’ people obey the assumptions
What are the methods for evaluating theories?
Congruence with reality - how well can the theory fit the observations?
Generality - good theories apply widely
Tractability - complex theories are more difficult to apply
Parsimony - Occams razor: what can be done with fewer assumptions is done in vein with more
Outline the history of behavioural economics
Psychology came into economics during neoclassical revolution of 1870s
Psychology largely departed from economics in the so called ordinal & revealed preference revolutions of 1930s
Behavioural economics in its modern form emerged in the late 1970s and has since been part of the mainstream
Outline the different methods of behavioural economics
Theory - model with better psychological assumptions
Experiments - controlled interactions in economics labs
Neuro-imaging
- Position emission tomography
- Functional magnetic resonance imaging
- Electroencephalography
- Regional cerebral bloodflow
What are the advantages of experiments?
Most econ theory is set off base of assumptions - ceteris paribus.
in real world this is never met, controlled experiments allow theory to be tested in conditions where ceteris paribus can more or less be met allowing the experimenter to control conditions and observe if there is a direct relationship between two variables
What are the characteristics and properties of risk averse individuals?
A risk averse individual will always refuse a fair prospect.
They have decreasing marginal utility and a concave utility function
What are the characteristics of a risk neutral individual?
Person is indifferent between accepting and refusing a fair gamble
they have constant returns to utility and a 45 degree line utility function
What are the characteristics of a risk loving individual?
Person will always accept a fair gamble.
They have increasing marginal utility and a convex utility function
What are the axioms of EUT? (normative claims of EUT to be the rational way of making decisions)
Completeness: For lotteries A & B either A>B, B>A or person is indifferent
Transitivity: If A>B and B>C then A>C
Continuity: For all lotteries A,B & C, if A>B and B>C then there exists a unique probability, p, such that lottery pA+(1-p)C is indifferent to B
Independence (common consequence axiom): For all lotteries A,B,C with A>B, then for all t values between 0 & 1, the lottery tA+(1-t)C is preferred to lottery tA+(1-t)C
What is the Allias paradox? (notes for more detail)
The Allias paradox is inconsistency.
It breaks the independence axiom as most people switch from 1a to 2b even though when the common consequence is removed, you are left with the same two choices
What is the Reflection effect?
The idea that we have different preferences over positive and negative outcomes.
Risk averse in gain domain
Risk loving in loss domain
What is the Isolation effect? (notes for more detail)
Idea that people will isolate gamble from initial income
