LECTURE SIX ECONOMIC CHOICE UNDER CONDITION OF UNCERTAINTY

Question 1

What is Expected Monetary Value (EMV)?

Answer 1

The sum of each possible payoff multiplied by its associated probability. It represents the mean value of a random investment or decision outcome.

Question 2

What are the three main attitudes toward risk?

Answer 2

1. Risk Neutrality 2. Risk Aversion 3. Risk Preference

Question 3

What characterizes a risk-neutral person?

Answer 3

They are indifferent between taking gambles or sure things and have a linear utility function. They make decisions purely based on expected monetary value.

Question 4

What characterizes a risk-averse person?

Answer 4

They prefer sure things to fair gambles and have a curved utility function with decreasing slope

Question 5

What characterizes a risk-preferring person?

Answer 5

They prefer fair gambles to sure things and have a utility function that becomes steeper as income increases

Question 6

Why is ordinal utility not sufficient for decision-making under uncertainty?

Answer 6

Ordinal utility can give different answers depending on the scale of utility numbers chosen

Question 7

What is cardinal utility?

Answer 7

A stronger form of utility that places more restrictions on utility numbers

Question 8

What is the expected utility hypothesis?

Answer 8

The hypothesis that people evaluate possible payoffs in terms of utility and choose the gamble that yields the highest expected utility.

Question 9

How do you calculate Expected Monetary Value?

Answer 9

Multiply each possible payoff by its probability and sum all the results.

Question 10

What is a fair gamble?

Answer 10

A gamble where the amount required to play equals the gamble’s expected monetary return.

Question 11

What type of utility function does a risk-averse person have?

Answer 11

A concave utility function that shows diminishing marginal utility for income.

Question 12

What type of utility function does a risk-preferring person have?

Answer 12

A convex utility function that shows increasing marginal utility for income.

Question 13

What type of utility function does a risk-neutral person have?

Answer 13

A linear utility function with constant marginal utility for income.

Question 14

How does a risk-neutral person choose between investments?

Answer 14

They choose based solely on Expected Monetary Value

Question 15

Why is cardinal utility needed in uncertain situations?

Answer 15

It provides consistent decision-making results regardless of the utility scale used

Question 16

What is the key characteristic of decision-making under uncertainty?

Answer 16

The outcome depends on random elements outside the decision-maker’s control.

Question 17

How do probability distributions relate to investment choices?

Answer 17

They show the likelihood of different possible payoffs occurring for each investment option.

Question 18

What information does a Von Neumann-Morgenstern utility function reveal?

Answer 18

It reveals an agent’s attitude toward risk through their preferences between certain and uncertain outcomes.

Question 19

What makes risky prospects different from regular consumer choice?

Answer 19

Regular consumer choice involves known bundles

Question 20

How does diminishing marginal utility relate to risk aversion?

Answer 20

Risk-averse individuals show diminishing marginal utility for income

Question 21

What role do probabilities play in calculating expected utility?

Answer 21

They weight each possible outcome’s utility in determining the overall expected utility of a choice.

Question 22

When comparing investments

Answer 22

what factors should be considered beyond EMV?

Question 23

How can utility functions help predict investment decisions?

Answer 23

By showing whether someone is risk-averse

Question 24

What is the relationship between certainty and risk in decision-making?

Answer 24

Certain outcomes have known values