Decision under risk

Question 1

What are the neoclassical psychological assumptions?

Answer 1

1) Costlessly process info. 2) Bayesian prob. operators 3) Discount time exponentially 4) Governed by selfish concerns 5) Maximise E(U)

Question 2

What are the methods for evaluating theories?

Answer 2

1) Congruence - fit with reality 2) Generality - how widely it applies 3) Tractability - complex theories harder to apply 4) Parsimony - Less assumptions

Question 3

Incorrect assumptions leads to incorrect theory, true or false.

Answer 3

False, theory can still be correct despite the assumptions.

Question 4

What is the Hawthorne effect?

Answer 4

When people change their behaviour as they know they are being watched.

Question 5

What is the standard Expected Utility theory?

Answer 5

E(U) = Σ[p_i U(x_i)]

Question 6

What is a fair prospect in standard theory?

Answer 6

Expected Value = 0 (NOT EU)

Question 7

What are the risk attitudes towards a fair prospect?

Answer 7

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.

Question 8

What are the axioms of expected utility theory?

Answer 8

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

Question 9

What is Allais’ Paradox?

Answer 9

• Violation of independence - Adding a common consequence alters decisions

Question 10

What is reflection effect?

Answer 10

Different risk preferences over losses vs gains - preferences were thought to be stable

Question 11

What is the event splitting effect?

Answer 11

• By splitting probability from one big two small alter decisions. -eg. 0.3(8) + 0.3(8) doesn’t equal 0.6(8)

Question 12

What is stochastic dominance?

Answer 12

• When probability is moved from a bad outcome to a good one. - EUT would never choose a stochastically dominated option

Question 13

What is Prospect theory?

Answer 13

EU = Σ[w(p_i) V (x_i - r)]

w = weighting

V - value function

r = reference value

Question 14

What is coding in the editing stage of prospect theory?

Answer 14

Changing the reference value -eg. min gain, income, social benchmark

Question 15

What is combination in the editing phase of prospect theory?

Answer 15

• prospects simplified by combining identical outcomes -eg. 0.25(10) + 0.25(10) = 0.5(10)

Question 16

What is the segregation phase of editing in prospect theory?

Answer 16

• segregates risk-less component from risky one - eg. (500,0.5 ; 700,0.5) =500 + (0,0.5 ; 200,0.5)

Question 17

What is cancellation in the editing phase of prospect theory?

Answer 17

Discarding of components that are shared by the offered prospects

Question 18

What is the Shape of the value function and what does it imply?

Answer 18

• 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

Question 19

What is the shape of the weighting function and what does this imply?

Answer 19

-Convex upward slope - Low probabilities are overweighted - High probabilities are under weighted. - Undefined close to 0

Question 20

What is subcertainty?

Answer 20

• Sum of weighted p values is less than 1 - w(p) + w(1-p) < 1 - Larger p values are underweighted

Question 21

What is sub proportionality?

Answer 21

-for a fixed ratio of p’s, the ratio of corresponding decision weights is closer to one when the p’s are small

Question 22

How does prospect theory deal with the issue of Allais’ Paradox?

Answer 22

• Implies sub-certainty - Use algebra and inequality to show that sum of w(p) < 1

Question 23

How does prospect theory explain the reflection effect?

Answer 23

• Shape of the value function shows that we are risk loving over losses and risk averse over gains

Question 24

How does prospect theory handle the issue of the isolation effect?

Answer 24

• Isolation effect solved by segregation - Takes diskless component out of decision.

Question 25

How does prospect theory solve event splitting effects?

Answer 25

• 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.

Question 26

How does Prospect theory solve stochastic dominance issues?

Answer 26

• 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!