Expected Utility Theory Flashcards
What did Daniel Bernoulli suggest about the EVT? What did he think was wrong with EVT?
People don’t value increases in wealth in a linear fashion.
What can explain why people are not willing to pay infinitely much to play ST. Petersburg game one time?
Diminishing marginal utility.
The idea of diminishing marginal utility is similar to what findings in psychophysics?
The Weber-Fechner law.
What is diminishing marginal utility?
The phenomenon that each additional unit of gain leads to an ever-smaller increase in subjective value
What does EVT assume about the way people value wealth?
They value it in a linear fashion.
In terms of EUT, what does the U represent?
Utility, which is how much they value the outcome.
Decreasing marginal utility can explain why people…
- Purchase insurance
- Are not indifferent to games with EV = 0
- Are risk averse.
What does this ~ symbol indicate?
Indicates indifference.
What is completeness?
Either x > y, y > x, or x ~ y
What is transitivity?
x > y and y > z imply x > z
What is continuity?
If x > y > z, there exists a probability p such that y ~ (x, p, z)
What is independence of irrelevant alternatives?
If x > y when choosing between x and y, then x > y when choosing between x, y, and z.
What provides the necessary and sufficient conditions for EUT?
Axioms
Why is it important that axioms provides the necessary and sufficient conditions for EUT?
- Axioms provide appealing normative justification of EUT. IF axioms considered normative, then EUT considered normative.
- Can test EUT as a descriptive theory by testing axioms. If people’s preferences satisfy axioms, then behavior can be
described as maximization of EU.
Risk aversion entails a ___________ function.
concave
