decision under risk Flashcards
Hard core
people are rational (transitivity and completeness)
Physchological assumptions of neoclassical economics
- Costlessly process information
- Bayesian probability operators. A way of determining payoff from pre determined probabilities.
- Discount time exponentially
- Are governed by selfish concerns.
Maximise expected utility
What does ‘as if’ mean
Economic theory shouldn’t be judged on the realism of its assumptions but on how well the predictions of the theory explain behaviour. Ronnie O’sullivan example.
Evaluating theories
- Congruence with reality
- Generality
- Tractability
- Parsimony
Advantages of experiments
Control you have in a lab, instruct, set up incentives. Can recreate ‘ceteris paribas’
Disadvantages of experiments
Hawthorne effect - where subjects behave differently inside a lab
Axioms of EUT
- Rationality (completeness and transitivity)
- Continuity
- Independence - assumed to be preferred at all different ratios
Allais paradox
Shows that a common consequence violates the independence axiom
common consequence
When something is added to both options
Reflection effect
People have different risk preferences between positive and negative outcomes. +ve = risk averse. -ve = risk taker
Isolation effect
Where the individual lightens the cognitive load
How to eliminate event splitting effect
Use stripped down prospect theory hence W(0.3) + W(0.3) may not equal W(0.6)
Assumptions in the editing process
Coding assumption
Combination assumption
Segregation assumption
Cancellation
Properties of the value function
Loss aversion
Diminishing sensativity
Reference point
Loss aversion
Losses are larger than gains. Disposition effect in the stock market - people hold onto stocks that lose value and eager to sell gains.
Diminishing sensitivity
Marginal utility falls as we move further away from the reference point. Risk averse preferences over gains and risk loving preferences over losses.
Reference point
V(0) = 0. Outcomes judged in terms of gains and losses. ‘Happiness treadmill’ like winning the lottery, it’s all about expectation.
Weighting function characteristics
- w(0) = 0 and w(1) = 1
- increasing in p
- Not defined close to zero and one.
- Subproportionality
- overweighting
- sub certainty
According to prospect theory, gains loom larger than gains. True or false
False
According to prospect theory, the probability weighting function can be decreasing in the objective probability p. True or false
False
According to prospect theory, small probabilities tend to be underweighted. True or false
False
Prospect A: (£10,1)
Prospect B: (£50,0.1; £10,0.89; £0,0.01) under expected utility
U(10) = 0.1U(50) + 0.89U(10) 0.11(10) = 0.1U(50)
Prospect A: (£10,1)
Prospect B: (£50,0.1; £10,0.89; £0,0.01) under prospect theory
w(1)V(10) = w(0.1)V(50) + w(0.89)V(10)
V(10) = w(0.1)V(50) + w(0.89)V(10)
subtract w(0.89)V(10) from both sides.
{1-w(0.89)}V(10) = w(0.1)V(50)
Prospect theory can resolve Allais’ paradox when preferences satisfy what?
Subcertainty
The independence axiom is that a common consequence added to all lotteries will not change choice behaviour. True or false
True
A risk averse person will refuse a fair gamble. True or false
True
A difficulty with testing economic theory in laboratories is that the ceteris paribus assumption cannot be made to hold
False
According to the levels puzzle, empirically observed levels of tax compliance are too low to be accounted for by expected utility theory. True or false
False - observed levels are too high
In the standard tax compliance model (as in lecture notes) a taxpayer is fined on all undeclared income at the rate F > 0 if caught evading . true or false
False - F in practice is between 0.1 and 1.
The overweighting of small probabilities under prospect theory helps to resolve the levels puzzle. True or false
True
Event-splitting effects are consistent with the prospect theory assumption of loss aversion. True or false
False - event splitting can only be resolved by using stripped down prospect theory.
Segregation in the editing phase of prospect theory can account for the isolation effect
True
If lottery A can be built from lottery B by moving some of the probability weight in B towards a better outcome, then B stochastically dominates A
False
