Decision under risk Flashcards
What are the neoclassical psychological assumptions?
1) Costlessly process info. 2) Bayesian prob. operators 3) Discount time exponentially 4) Governed by selfish concerns 5) Maximise E(U)
What are the methods for evaluating theories?
1) Congruence - fit with reality 2) Generality - how widely it applies 3) Tractability - complex theories harder to apply 4) Parsimony - Less assumptions
Incorrect assumptions leads to incorrect theory, true or false.
False, theory can still be correct despite the assumptions.
What is the Hawthorne effect?
When people change their behaviour as they know they are being watched.
What is the standard Expected Utility theory?
E(U) = Σ[pi U(xi)]
What is a fair prospect in standard theory?
Expected Value = 0 (NOT EU)
What are the risk attitudes towards a fair prospect?
1) R. Averse: Will always avoid a fair prospect 2) R. Neutral: Indifferent between accepting and leaving 3) R. Loving: Will always accept fair prospect.
What are the axioms of expected utility theory?
1) Completeness - all have rank 2) Transitivity - if a>b and b>c, then a>c 3) Continuity - p(A) + (1-p)C = B 4) Independence - common consequence
What is Allais’ Paradox?
- Violation of independence - Adding a common consequence alters decisions
What is reflection effect?
Different risk preferences over losses vs gains - preferences were thought to be stable
What is the event splitting effect?
- By splitting probability from one big two small alter decisions. -eg. 0.3(8) + 0.3(8) doesn’t equal 0.6(8)
What is stochastic dominance?
- When probability is moved from a bad outcome to a good one. - EUT would never choose a stochastically dominated option
What is Prospect theory?
EU = Σ[w(pi) V (xi - r)]
w = weighting
V - value function
r = reference value
What is coding in the editing stage of prospect theory?
Changing the reference value -eg. min gain, income, social benchmark
What is combination in the editing phase of prospect theory?
- prospects simplified by combining identical outcomes -eg. 0.25(10) + 0.25(10) = 0.5(10)
What is the segregation phase of editing in prospect theory?
- segregates risk-less component from risky one - eg. (500,0.5 ; 700,0.5) =500 + (0,0.5 ; 200,0.5)
What is cancellation in the editing phase of prospect theory?
Discarding of components that are shared by the offered prospects
What is the Shape of the value function and what does it imply?
- Shape is an S going through the origin. - Loss aversion as the curve is steeper below the origin - Diminishing sensitivity (concave) RA over gains and RL over losses - reference point is v(0) = 0
What is the shape of the weighting function and what does this imply?
-Convex upward slope - Low probabilities are overweighted - High probabilities are under weighted. - Undefined close to 0
What is subcertainty?
- Sum of weighted p values is less than 1 - w(p) + w(1-p) < 1 - Larger p values are underweighted
What is sub proportionality?
-for a fixed ratio of p’s, the ratio of corresponding decision weights is closer to one when the p’s are small
How does prospect theory deal with the issue of Allais’ Paradox?
- Implies sub-certainty - Use algebra and inequality to show that sum of w(p) < 1
How does prospect theory explain the reflection effect?
- Shape of the value function shows that we are risk loving over losses and risk averse over gains
How does prospect theory handle the issue of the isolation effect?
- Isolation effect solved by segregation - Takes diskless component out of decision.
How does prospect theory solve event splitting effects?
- It doesn’t - ESE violates combination phase of editing - can use stripped down model which doesn’t allow for combination - in this 2 x w(0.3) doesn’t equal 0.6 so explains different results.
How does Prospect theory solve stochastic dominance issues?
- moving p has two effects on utility: 1) Direct - always positive, ^p on good outcome. 2) Indirect - + or -, sum of w(p) + w(1-p) may increase or decrease. *If indirect is negative, it outweighs the direct effect!
