Lecture 3: Expected Value and Utility Theory

Question 1

the gamble paradigm

Answer 1

making rational decisions in simple gambles

Question 2

expected value (EV)

Answer 2

the value of a future gain should be directly proportional to the chance of getting it

Question 3

null-bet

Answer 3

when the expected value is 0

Question 4

how to make rational decisions in simple gambles

Answer 4

• calculate the expected value of each option/alternative
• choose the one with the highest EV

Question 5

the expected value choice principle

Answer 5

choose the alternative with the highest EV

Question 6

the expected value evaluation principle

Answer 6

the value of an alternative is equal to its EV

Question 7

challenge for EV

Answer 7

St. Petersburg Paradox
- flip a goin and play until you flip tails
- round1: tails pays out 1 euro and ends game, heads doubles and repeated until tails
- EV = infinite

Question 8

utility of wealth

Answer 8

according to Daniel Bernoulli, the utility of wealth follows the logarithmic function
- “the utility resulting from any small increase in wealth will be inversely proportional to the quanitity of goods already possessed”
- Expected Value ≠ Expected Utility

Question 9

utility

Answer 9

the amount of joy, pleasure, or satisfaction you get from consuming or acquiring something

Question 10

2 things in simple economics which determine what people do

Answer 10

• the pleasure people get from doing or consuming something
• the price of doing or consuming that something

Question 11

decision utility

Answer 11

anticipated pleasure you feel at the time of decision

Question 12

experienced utility

Answer 12

pleasure you actually feel from the consequences of your choice

Question 13

total utility

Answer 13

refers to the satisfaction one gets from one’s consumption of a product

Question 14

marginal utility

Answer 14

the satisfaction you get from the consumption of one additional unit of a product above and beyond what you have consumed up to that point

Question 15

diminishing marginal utility

Answer 15

after some point, the marginal utility received from each additional unit of a good decreases with each additional unit consumed

Question 16

rational choice and marginal utility

Answer 16

it is a basic principle of rational choice that you should spend your money on those goods that give you the most marginal utility per dollar

Question 17

Ward Edwards

Answer 17

founder of behavioral decision theory

Question 18

behavioral decision theory

Answer 18

an interdisciplinary discipline that addresses the question of how people actually confront decisions, as opposed to the question of how they should make decisions
- descriptive theory of decision making whereas economic theory is normative

Question 19

theory of riskless choice

Answer 19

how people make decisions when there is no uncertainty involved with their decision
- most important assumption: the decision maker is considered to be an economic man

Question 20

economic man

Answer 20

completely informed
- knows what alternatives are out there and what consequences they have
infinitely sensitive
- can make distinctions between all sorts of products and see all their differences
rational
- can weakly order states and can choose to maximize something

Question 21

economic man can weakly order states

Answer 21

A > B, or A < B, or A = B

Question 22

transitivity of preferences

Answer 22

if A > B, and B > C, then A must be > C
- if not true, you are intransitive which can lead to becoming a victim of a money pump

Question 23

money pump

Answer 23

pay to trade A for C, pay to trade C for B, pay to trade B for A, and repeat

Question 24

economic man maximizes something

Answer 24

central principle in theory of rational choice
- typically assumed to maximize utility

Question 25

early utility maximizing theory

Answer 25

goal of human actions is seeking pleasure and avoiding pain

Question 26

competing goods utility

Answer 26

• the utility derived from one competing good reduces the utility derived from the other
• consumers aim to maximize their total utility by choosing the product that offers the highest satisfaction, given the prices and preferences

Question 27

completing goods utility

Answer 27

• the utility derived from complementary goods increases when both are consumed together
• the combined utility of using both goods together is greater than the sum of their individual utilities, as they enhance each other’s value when used in conjunction

Question 28

Francis Y. Edgeworth

Answer 28

• non-independent utilities -> indifference curves

Question 29

indifference curves

Answer 29

curves that give you lines which have the same utility

Question 30

ordinal and cardinal utility

Answer 30

• ordinal utility is measured on an ordinal scale
• cardinal utility is measured on an interval scale

Question 31

ordinal vs cardinal utility

Answer 31

indifference curve analysis in its various forms could do everyting that cardinal utility could do, with fewer assumptions

Question 32

reinstating cardinal utility

Answer 32

Robertson pleaded for the reinstatement of cardinal utility in the interests of welfare economics

Question 33

the best economic policy

Answer 33

the economic policy is best which results in the maximum total utility, summed over all members of the economy

Question 34

Pareto’s principle

Answer 34

a change should be considered desirable if it left everyone at least as well off as they were before, and made at least one person better off

Question 35

compensation principle (Kaldor)

Answer 35

if it is possible for those who gain from an economic change to compensate the losers for their losses, and still have something left over from their gains, then the change is desirable

Question 36

theory of risky choices

Answer 36

choices where you don’t know beforehand what the outcome will be

Question 37

risk vs uncertainty

Answer 37

• risk refers to known probabilities
• uncertainty refers to unknown probabilities

Question 38

expected utility maximizing

Answer 38

the expected value of a bet is found by multiplying the value of each possible outcome by its probability of occurrence and summing these products across all possible outcomes
- contradicted by observable behavior in many risky situations

Question 39

theory of games and economic behavior (Von Neumann-Morgenstern)

Answer 39

• risky propositions can be ordered in desirability, just as riskless ones can
• choices among risky alternatives are made in such a way that they maximize expected utility

Question 40

Markowitz

Answer 40

suggested that the origin of a person’s utility curve for money to be taken as his customary financial status
- if the person’s customary state of wealth changes, then the shape of his utility curve will thus remain generally the same with respect to where he is now
- his risk-taking behavior will remain pretty much the same instead of changing with every change of wealth

Question 41

Mosteller and Noggee

Answer 41

carried out the first experiment to apply the Neumann-Morgenstern model
- the hypothesis that subjects maximized expected utility predicted choices better than the hypothesis that subjects maximized expected money value
- showed that people are sensitive to changes with respect to the current situation

Question 42

2 factors Edwards found most important in determining choices

Answer 42

• general preferences or dislikes for risk-taking
• specific preferences

Question 43

general preferences or dislikes for risk taking

Answer 43

strong preference for low probabilities of losing large amounts of money to high probabilities of losing small amounts of money
- just didn’t like to lose

Question 44

subjective probability

Answer 44

an individual’s personal judgment or belief about how likely an event is to occur, rather than relying on objective or statistical probabilities

Question 45

transitivity in decision making

Answer 45

transitivity can never be violated
- since choices will be made in sequence, it can always be argued that the person may have changed their tastes between the first and third choice