Expected Value (Class 2)

Question 1

What is a normative model?

Answer 1

It attempts to describe how we SHOULD behave (normative = normal = we should do what’s normal)

Question 2

What is a descriptive model?

Answer 2

It attempts to describe how we actually behave. (A description of how we behave).

Question 3

Which do you prefer?
– Option A: $10 with probability 0.80 (otherwise nothing)
OR

– Option B: $12 with probability 0.50 (otherwise nothing)

• Most people prefer A. Why?

Answer 3

It’s better on average in the long run. ‘A’ has higher expected value.

Question 4

How do you calculate expected value?

Answer 4

You calculate the value of each value by multiplying the value of each of its outcomes by its probability.

Question 5

Calculate the expected value of this game.

Heads wins, get $4; Tails, lose $2

Answer 5

(.5)($4) + (.5)(-$2) = $2 - $1 = $1

Question 6

What are some descriptive shortcomings of EVT?

Answer 6

• People accept gambles with negative EV
• People pay premiums
• People are no indifferent to games with EV = 0.

Question 7

Is EVT normative or descriptive?

Answer 7

Neither!

Question 8

What proves the EVT isn’t normative?

Answer 8

The St. Petersburg Game. In theory, you should give up everything…

Question 9

Who came up with the St. Petersburg Game?

Answer 9

Nicholas Bernoulli

Question 10

What proves that EVT isn’t descriptive?

Answer 10

People take gambles with low expected value.

Question 11

What proves that EVT isn’t normative?

Answer 11

St.Petersburg Game