Lecture 8: Decision-making Flashcards
What is riskless multiattribute choice?
select between 2 or more options that differ in 2 or more attributes (e.g., choosing between 3 phones that differ in price, screen size and battery life)
what is intertemporal choice?
one of the attributes that varies is time (e.g., would you rather receive £10 now, or £25 one year from today)
what are decisions under uncertainty (risky)?
one or more of the possible outcomes are probabilistic (i.e., they are not certain to occur). sometimes the probabilities are not known precisely, in which case the decision may be referred to as “under uncertainty” or “under ambiguity”
can risk and uncertainty be used interchangeably?
some authors use “risk” and “uncertainty” interchangeably to mean situations whose outcomes are probabilistic
what is the expected value?
the expected value (EV) of an option is the sum of each possible outcome weighted by its probability
what is the equation for the expected value?
EV = p1a1 + p2a2 + p3a3 + … pnan
a= the value of the outcome
p= the probability of the outcome
n= the total number of outcomes
what can risky choices be made from?
- “from description” –> information about the options is explicitly presented - e.g., in writing
- “from experience” –> the decision-maker has to learn the outcomes and their probabilities by repeatedly sampling the environment
how did a study that people are risk averse for gains?
option a: an 80% chance of £4000
option b: £3000 for sure
under the expected value:
EV(A) = 0.8 x £4000 + 0.2 x £0 = £3200
EV(B) = 1.0 x £3000 = £3000
80% of people chose B, meaning they are ‘risk averse’ for gains
what is expected utility?
utility can be thought of as the subjective value of an outcome, and is some transformation u(a) of the objective amount
what is the equation for expected utility?
EU = p1u(a1) + p2u(a2) + … pnu(an)
does expected utility have the assumption of rationality?
yes, they conform to and follow from a set of axioms whose reasonableness it is hard to dispute.
Under expected utility theory, which option do people choose?
Option A: an 80% chance of £4000
Option B: £3000 for sure
EU(A) = 0.8 x u(4000) + 0.2 x u(0) = 0.8 x 145 = 116
EU(B) = 1.0 x u(3000) = 1.0 x 122 = 122
The preference for B simply requires that the utility of £3000 is more than 80% of the utility of £4000
what is a limitation of expected utility?
it is a poor amount of reality
what is reference dependence?
outcomes considered as gains or losses with respect to a reference point - often the status quo
what attitudes do people have for perceived gains and losses
risk averse for (perceived) gains
risk seeking for (perceived) losses
what is the endowment effect?
describes how people tend to value items that they own more highly than they would if they did not belong to them
give an example of the allais paradox?
PROBLEM 1:
Option A:
-£2500 with probability 0.33
-£2400 with probability 0.66
-£0 with probability 0.01
Option B:
-£2400 with certainty
82% chose B
PROBLEM 2:
Option C:
-£2500 with probability 0.33
-£0 with probability 0.67
Option D:
-£2400 with probability 0.34
-£0 with probability 0.66
83% chose C
what is the certainty effect?
- people disproportionately weight outcomes which are guaranteed to occur [or not occur]
so that: - “a reduction of the probability of an outcome by a constant factor has more impact when the outcome was initially certain than when it was merely probable”
what are non-linear probabilities?
people seem to overweight extreme probabilities and under-weight moderate-to-large ones
what is a decision-weights function?
a non-linear mapping between stated probabilities and the weight given to the corresponding outcome when forming an overall evaluation of a prospect
what can prospect theory be summarised into?
- editing
- reference point
- valid function
- decision weights
what are 3 problems with prospect theory?
- limited scope
- empirical findings
- purely descriptive
how is limited scope a limitation of prospect theory?
there are violations of rationality in risky choice which prospect theory doesn’t address
e.g.,
- people’s valuations of two gambles can contradict their choices when asked to pick between them
- the same instability is illustrated by decoy effects. a famous example is the asymmetric dominance effect (a.k.a. the attraction effect), a widely-used marketing trick
what is the peanut effect?
people don’t mind taking a risk when playing for peanuts
why is prospect theory being purely descriptive a limitation?
- lack of mechanism
- brings in more questions, e.g., where do the curves come from?
