LECTURE SIX ECONOMIC CHOICE UNDER CONDITION OF UNCERTAINTY Flashcards
What is Expected Monetary Value (EMV)?
The sum of each possible payoff multiplied by its associated probability. It represents the mean value of a random investment or decision outcome.
What are the three main attitudes toward risk?
- Risk Neutrality 2. Risk Aversion 3. Risk Preference
What characterizes a risk-neutral person?
They are indifferent between taking gambles or sure things and have a linear utility function. They make decisions purely based on expected monetary value.
What characterizes a risk-averse person?
They prefer sure things to fair gambles and have a curved utility function with decreasing slope
What characterizes a risk-preferring person?
They prefer fair gambles to sure things and have a utility function that becomes steeper as income increases
Why is ordinal utility not sufficient for decision-making under uncertainty?
Ordinal utility can give different answers depending on the scale of utility numbers chosen
What is cardinal utility?
A stronger form of utility that places more restrictions on utility numbers
What is the expected utility hypothesis?
The hypothesis that people evaluate possible payoffs in terms of utility and choose the gamble that yields the highest expected utility.
How do you calculate Expected Monetary Value?
Multiply each possible payoff by its probability and sum all the results.
What is a fair gamble?
A gamble where the amount required to play equals the gamble’s expected monetary return.
What type of utility function does a risk-averse person have?
A concave utility function that shows diminishing marginal utility for income.
What type of utility function does a risk-preferring person have?
A convex utility function that shows increasing marginal utility for income.
What type of utility function does a risk-neutral person have?
A linear utility function with constant marginal utility for income.
How does a risk-neutral person choose between investments?
They choose based solely on Expected Monetary Value
Why is cardinal utility needed in uncertain situations?
It provides consistent decision-making results regardless of the utility scale used
What is the key characteristic of decision-making under uncertainty?
The outcome depends on random elements outside the decision-maker’s control.
How do probability distributions relate to investment choices?
They show the likelihood of different possible payoffs occurring for each investment option.
What information does a Von Neumann-Morgenstern utility function reveal?
It reveals an agent’s attitude toward risk through their preferences between certain and uncertain outcomes.
What makes risky prospects different from regular consumer choice?
Regular consumer choice involves known bundles
How does diminishing marginal utility relate to risk aversion?
Risk-averse individuals show diminishing marginal utility for income
What role do probabilities play in calculating expected utility?
They weight each possible outcome’s utility in determining the overall expected utility of a choice.
When comparing investments
what factors should be considered beyond EMV?
How can utility functions help predict investment decisions?
By showing whether someone is risk-averse
What is the relationship between certainty and risk in decision-making?
Certain outcomes have known values
