ST3 - An Analysis of Decision under Risk

Question 1

What is expected utility theory?

Answer 1

the DM compares the expected utilities of different alternatives and chooses the one with the highest utility

Question 2

What are the three tenets for expected utility theory?

Answer 2

1. Expectation (the overall utility of a prospect is the expected utility of its outcomes)
2. Asset Integration (a prospect is acceptable if the utility resulting from integrating the prospect with one’s assets exceeds the utility of the assets alone)
3. Risk Aversion (u is concave)

Question 3

What is the certainty effect?

Answer 3

People overweight certain outcomes relative to outcomes which are merely probable

Question 4

What is the reflection effect?

Answer 4

If positive prospects are changed into negative prospects (from gains to losses), the preference order is reversed

Question 5

What is probabilistic insurance?

Answer 5

reducing the probability of a loss from p to p/2 is less valuable than reducing it from p/2 to 0. But according to Expected Utility Theory, implies that probabilistic insurance is superior to regular insurance

Question 6

What is the isolation effect?

Answer 6

in order to simplify the choice between alternatives, people often disregard components that the alternatives share, and focus on the components that distinguish them

Question 7

What are the two phases of prospect theory?

Answer 7

1. Editing phase
2. Evaluation phase

Question 8

What is the editing phase?

Answer 8

preliminary analysis of offered prospects and simpler representation of those - organize and reformulate the options so as to simplify the subsequent evaluation and choice

Question 9

What are the editing operations?

Answer 9

• Coding
• Combination
• Segregation
• Cancellation
• Simplification
• Detection of dominance

Question 10

What is coding?

Answer 10

rank the outcomes as gains or losses

Question 11

What is combination?

Answer 11

combine probabilities associated with identical outcomes

Question 12

What is segregation?

Answer 12

riskless components are segregated from the risky component

Question 13

What is cancellation?

Answer 13

discard components that are shared by prospects

Question 14

What is the evaluation phase?

Answer 14

edited prospects are evaluated and prospect with highest value is chosen

Question 15

What is a reference point?

Answer 15

How valuable something is, does not depend on the final state (final outcome) but rather on the change in wealth or welfare = where am I now (reference point) and where will I be if I chose that action/outcome

Question 16

What about the steepness of the value function?

Answer 16

Utility functions for losses are steeper than for gains => losses loom larger than gains

Question 17

What is the form of the value function?

Answer 17

concave for gains, convex for losses, S-shaped

Question 18

What are decision weights?

Answer 18

Decision weights measure the impact of events on the desirability of prospects and not the perceived likelihood of these events