Lecture 4 Risk Preferences Flashcards
What are the risk preferences of the homo economicus?
It obeys the principles of expected utility theory
What is the conclusion of the paper of Bernoulli (1738)?
People have risk-averse preferences and therefore people maximize expected utility and not expected monetary value
Diminishing Marginal Utility
The same amount of additional money is less useful to an already-wealthy person than it would be to a poor person
Expected Utility Theory (EUT)
Describes how people should make decisions by means of rational computations based on objective outcomes and probabilities, without cognitive limitations and emotions
What are the important and less important underlying principles for the EUT?
- Independence
- Invariance
- Asset integration
Completeness
Transitivity
Continuity
Reduction
Monotonicity
Risk aversion
Invariance
Different representations of the same choice problem should yield the same preferences
What are two forms of invariance and what do they mean?
Description invariance (how distributions are described)
Procedure invariance (method used to elicit preferences)
Asset Integration
Final wealth states matter, not just prospect outcomes that means that risk preferences are affected by the size of the gamble relative to a person’s wealth
What are two EUT violating discoveries by Maurice Allais for Independence (1953)?
The common Consequence effect (the “Allais Paradox”)
Common ratio effect
The common Consequence effect (the “Allais Paradox”)
A common consequence effect (CCE) occurs if the preference between two lotteries changes if the same probability mass is shifted from one common outcome to a different common outcome in both lotteries.
Common ratio effect
The effect that people tend to choose more for a certain amount lower than a higher expected value.
What is a third violation of the EUT rule of invariance, the asian disease?
The framing effect (framing the question different will effect the answer)
What does the fourth violation of EUT of Rabin’s Critique entails?
The bigger the amount we can lose, the more risk averse we become. plausible risk-aversion at small
stakes implies implausible risk-aversion at large stakes to lose.
Prospect Theory
The gain/loss framing is the cornerstone. People will tend choose more for a gain than a loss even the situation is the same
Certainty effect
A reduction of the probability of an outcome by a constant factor has more impact on the decision weight when the outcome was initially certain than when it was merely probable.
