Individual Decision Making

Question 1

Risk v. uncertainty

Answer 1

Risk = defined outcomes and probabilities of each occurring
Uncertainty = defined outcomes but don't know probabilities

Question 2

The economic approach to human behaviour (?;?)

Answer 2

Becker 1976
Assumes:
- maximising behaviour (of wealth/utility)
- preferences are stable (over time/between people)
Doesn't distinguish between:
- major / minor decisions
- strong / little emotion
- income, education and background

Question 3

Expected value

Answer 3

the average value of an act, weighted by probability
EV = £
The same for all people

Question 4

The St Petersburg Paradox

Answer 4

EV analysis implies risk neutral decision-maker

BUT most people are risk averse

Question 5

Expected Utility Theory (?;?)

Answer 5

Bernoulli 1738
Poor and rich see risk and gain differently
= value must be based on utility not price
–> utility can change with circumstances
We have diminishing marginal utility = increase in wealth results in increase in utility inversely proportionate to quantity of goods already possessed

Question 6

Axioms of rationality (?)

Answer 6

von Neumann-Morgenstern
Completeness = either prefer A or B or are indifferent
Transitivity = if A is better than B and B is better than C then A is better than C
Continuity = if A>B>C then some combo of A and C should make them indifferent between that and B
Independence = A>B regardless of any given C

Question 7

Allais Paradox (?;?) (?;?)

Answer 7

against independence axiom
List and Haigh 2005 - both students and traders are in line with it
Oliver 2003 - tested it with health outcomes rather than money - again independence was violated

Question 8

Ellsberg Paradox (?)

Answer 8

1961
we are ambiguity averse = prefer the gamble when we know what the probability is
Violates independence axiom

Question 9

Risk aversion (?;?)

Answer 9

Rabin and Thaler 2001
Using EU to explain risk aversion over moderate stakes implies absurdly large risk aversion over large stakes
V. reality - most prefer large stakes
Implies people depart from risk neutrality only when facing prospects that might have a major effect on lifetime wealth = false

Question 10

Loss aversion (?;?)

Answer 10

Tversky and Kahneman 1991
People perceive losses worse than gains
Potential explanation for the Allais paradox

Question 11

Alternative model to EU theory (?;?)

Answer 11

Quiggin 1982
Anticipated Utility theory
-weaker form of independence axiom
-permits nonlinear weighting or probabilities
-attitude determined by attitudes to possible outcome and attitudes to the probabilities