Lecture 10

Question 1

What is the allais paradox?

Answer 1

Choice problem to show an inconsistency of actual observed choices with the predictions of expected utility theory

Question 2

See notes for example for a,b,α and β. Explain the paradox. How do you prove your statement?

Answer 2

Most people would choose α over β, but b over a. Under utility maximisation this can’t occur since there is no utility function that can accommodate this. These preferences violate violation of independence axiom tf EU doesn’t hold. This is known as the common ratio problem/effect. Prove it by calculating the difference in expected utility

Question 3

What is the independence axiom?

Answer 3

For any prospect x, y and C:

x>=y -> x(p)C>=y(p)C

Question 4

See

Answer 4

Notes at bottom of page

Question 5

Explain the allais paradox II?

Answer 5

See example
People would usually choose a over b, but β over α. This goes against the sure thing principle tf violates it. Tf EU doesn’t hold for people exhibiting such preferences. This is an example of the common consequence problem, and the behavioural pattern is the common consequence effect

Question 6

Note

Answer 6

By applying EV and EU, we can see that in both the common ratio problem and common consequence problem neither EV or EU holds in the two problems

Question 7

What is the framing effect?

Answer 7

The way that choices are worded can affect how someone makes a decision (eg. Risk of losing 10/100 lives or opportunity of saving 90/100 lives). It is based on loss aversion

Question 8

What is loss aversion?

Answer 8

People’s tendency to prefer avoiding losses than acquiring equivalent gains

Question 9

Explain what preference reversal is and what it violates?

Answer 9

It’s the situation in which preferences for bundles are shifted after the options are juxtaposed - when bundles are view separately the decision made on the bundle is different than when they are valued jointly. This is due to relativity of choices. It is a violation of transitivity

Question 10

Explain the endowment effect?

Answer 10

The bias that occurs when we overvalue a good we own, regardless of its objective market value. Gives a reason for the gap between WTP and WTA. It can be explained by loss aversion attitudes

Question 11

What is status quo bias?

Answer 11

A bias that arises due to people preferring things to stay the same by doing nothing. (Eg. Not changing our bills to cheaper methods - if redoing the decision would probably sort it cheaper)

Question 12

What is the isolation effect?

Answer 12

The isolation effect refers to a phenomenon whereby people value a thing differently depending on whether it is placed in isolation or placed next to an alternative. Happens due to people disregarding the worst option as a common baseline and focus only on differences between alternatives. Also known as Von Restorff effect

Question 13

See

Answer 13

Slides 30 and 31 on framing effect and preference reversal!

Question 14

Read lecture 10 notes on breaking down the common ratio effect

Answer 14

Now

Question 15

Using L10:

What is someone who is consistent from step 1 to step 2?

Answer 15

Forgone-event independent:

What happened in the past should not make a difference to how you make your decision now

Question 16

Using L10:

What is someone who is consistent from step 2 to step 3?

Answer 16

Dynamically consistent/time independent:

If you decide for an action to be carried out tomorrow, then when tomorrow comes, you should commit to your decision

Question 17

Using L10:

What is someone who is consistent from step 3 to step 4?

Answer 17

Context independent:

Your decision is not influenced by the context or framing of the decision

Question 18

Using L10:

What is someone who is consistent from step 4 to step 5?

Answer 18

Reduction independent:

Your decision is not influenced by whether the decision is represented in complex or simple form