Lecture 2 - Risky Decisions

Question 1

What is the idea of the expected value?

Answer 1

The sum of all possible values each multiplied by the probability of its occurrence. (quantifying outcomes without human decisions taken into account);

Question 2

What is certainty equivalent?

Answer 2

The amount of money that will make people indifferent to receiving an amount of money or receiving a risky option.

Question 3

What does risk aversion mean?

Answer 3

The certainty equivalent is lower than the expected value of the risk option (thus people are unwilling to engage in it)

Question 4

What model explains people’s apparent distaste for risk?

Answer 4

Expected utility

Question 5

What makes expected utility different from expected value?

Answer 5

1)Expected utility is different in terms of not maximizing nominal value but rather a subjective utility.

2) EU - Utility is a transformation of value - diminishing marginal utility (the more money you have that add up, the less the increase of utility - i.e. 0 to 10 euros - 11.0 marginal utility, 10 to 20 euros - 9.0 - marginal utility - thus marginal utility diminishes.

Question 6

How do we calculate diminishing marginal utility with percentage probabilities?

Answer 6

We multiplty the total utility by the percentage of decrease - i.e. getting 100 euros with 70% probability = 0.7 * 46.1 =

Question 7

How do we calculate diminishing marginal utility with percentage probabilities?

Answer 7

We multiplty the total utility by the percentage of decrease - i.e. getting 100 euros with 70% probability = 0.7 * 46.1 =

Question 8

Why do we prefer to get something for sure rather than engaging in risk behaviour?

Answer 8

Because we would rather have something with full probability rather than the value of getting something additional that is not so big (diminishing marginal utility).

Question 8

Why do we prefer to get something for sure rather than engaging in risk behaviour?

Answer 8

Because we would rather have something with full probability rather than the value of getting something additional that is not so big (diminishing marginal utility).

Question 9

Why expected utility might not always be a great model to understand how people make decisions under risk?

Answer 9

Because while in gain frames (saving/winning highlighted as a definite factor of a certain percent) people are risk averse, in loss frames (losing highlighted as a definite factor of a certain percent), people are risk seeking.

Question 9

Why expected utility might not always be a great model to understand how people make decisions under risk?

Answer 9

Because while in gain frames (saving/winning highlighted as a definite factor of a certain percent) people are risk averse, in loss frames (losing highlighted as a definite factor of a certain percent), people are risk seeking.

Question 10

What is prospect theory?

Answer 10

People transform values in utilities through:

1) Reference dependence
2) Loss aversion
3) Diminishing sensitivity

Question 11

What is reference dependence?

Answer 11

Anything we experience in the world, we identify as a gain or a loss relative to some reference point.

Question 12

What can be a reference point?

Answer 12

Status quo/endowment
Expectations/aspirations
Norm (what others have)
I.e. - sleeping pill different costs

Question 13

What is loss aversion?

Answer 13

Given a change of similar magnitude, that change is much more powerful if it is a loss, than if it is a gain - based on reference point.

E.g. disutility (losing 10) > utility (earning 10)

Question 14

What is the endowment effect?

Answer 14

We are more likely to demand a bigger amount of money to give away an object than we are willing to spend to obtain that same object. (Disutility of losing a pen > utility of earning a pen) ; Once we have something, its value is increased (to us) once we lose it.

Question 15

What is the sunk cost fallacy?

Answer 15

When we pay money or have some investment, we are particularly likely to want to carry on with the committed efforts, despite the facts that the cost loss we suffered in the past is irrelevant. (i.e. not going to a concert if we paid money for it, makes us feel like losing something); if we get a free ticket, and don’t wanna go - then it is not a problem.

Question 16

What is diminishing sensitivity?

Answer 16

Going from 10 to 20 is better than going from 110 to 120. Going from -20 to -10 is worse than going from -110 to -120.

Question 17

Why should we separate gains and integrate losses?

Answer 17

Earning 10 twice is better than earning 20 once.
Losing 10 twice is worse than losing 20 once.

Question 17

Why should we separate gains and integrate losses?

Answer 17

Earning 10 twice is better than earning 20 once.
Losing 10 twice is worse than losing 20 once.

Question 18

What is probability weighting?

Answer 18

People do not act on probability but on some distorted (biased) version of this probability. Big probabilities are underestimated and small probabilities are overestimated.
If a probability is 60% - people act like the probability is little smaller than 60%.

Question 19

What is the fourfold pattern of risk attitudes?

Answer 19

Gain with moderate probability (50% of 100 or 50 euros for sure) - risk aversion - prefer 50 euros for sure

Gain with a small probability - 1% of getting 100 euros or 1 euro - risk-seeking - people will overestimate the 1% and will prefer it.

Losses with moderate probabilities - 50% of losing 100 euros vs -50 euros - risk-seeking - people underestimating the 50% of losing

Losses with small probabilities - 1% of losing 100$ or losing 1$ - risk aversion - people will overestimate the probability of losing 100$ and would choose to lose 1$ for sure.

Question 20

Through what is the endowment effect explained?

Answer 20

Reference dependence and diminishing sensitivity.

Question 21

Through what is the endowment effect explained?

Answer 21

Reference dependence and loss aversion.

Question 22

What are the determinants of accessibility? (Kahneman, 2003)

Answer 22

Physical salience.
Priming - activating certain associations