Lecture 9

Question 1

When calculating decision under uncertainty, what are the subjective parameters for EV and EU calculations?

Answer 1

For EV, the probability is subjective

For EU, both probability and utility are subjective

Question 2

When calculating decision under risk, what are the subjective parameters for EV and EU calculations?

Answer 2

For EV, no subjective parameters

For EU, utility is subjective

Question 3

Explain 3 steps to determining ones subjective probability, given they maximise EV?

Answer 3

1) give them prospects (eg. £1(win)£0)
2) ask them for their certainty equivalent to that prospect (CE(£1(win)£0)
3) apply EV to preference then calculate p(win)

See example in notes

Question 4

How to determine ones utility assigned to outcomes, if one maximises EU? (3 steps)

Answer 4

1) offer the subject many risky prospects and find their CEs to find all their indifferences
2) set u(100)=1, u(0)=0 (for easy calc.) and then apply EU to all the indifferences
3) using u(x) and x, sketch the utility function

Question 5

What is the common feature of the last 2 methods?

Answer 5

The standard gamble/CE method

Question 6

Explain drawbacks of the standard gamble/CE method?

Answer 6

• can’t be used for calculating utility for decision under uncertainty
• certainty effect (see book page 287)
• can only calculate utility of 2 outcomes(?)

Question 7

What is the certainty effect?

Answer 7

The certainty effect is that to get £x with certainty is worth more than getting a prospect that has the same expected utility (since that prospect will still probably include risk)

Question 8

What does the trade off method do? 2 advantages of it?

Answer 8

The method elicits indifferences of pairs of risky prospects

It complements the drawbacks of the standard gamble
Can calculate without using EU

Question 9

Why can the trade off method work without calculating expected utility?

Answer 9

Since α1,…αn yield equal utility intervals, the method holds whether we apply EU or not