Topic 3 - Part 1: Decision Making Under Risk & Uncertainty Flashcards
What theory has dominated economic analysis of choice under risk and uncertainty?
Expected Utility Theory (EUT).
In EUT, how are choices evaluated?
By maximizing expected utility rather than expected value.
What is a “prospect” in the context of decision-making under risk?
A contract that yields specific outcomes with assigned probabilities.
The (riskless) prospect that yields x with certainty is
denoted by:
(x)
Define Expected Utility
It is the probability-weighted average of utility values from potential outcomes (e.g. utility of monetary values).
Define Expected Value
The expected value (EV) of a prospect is the value of each possible outcome times the probability of that outcome
People do not seek to maximise expected values, but
instead seek to maximise ……….. ……..
expected utility
What does a concave utility function indicate?
Risk aversion
How does risk aversion affect choices between risky and certain prospects?
Risk-averse individuals prefer certain outcomes over risky ones with equal or higher expected value.
What is “asset integration” in EUT?
A prospect is acceptable if it increases the utility of a person’s assets.
How do risk-neutral individuals make decisions under risk?
They select the option with the highest expected value.
Diminishing marginal utility implies that the utility of the certain wealth is …….. than risky wealth.
higher
The concavity of the utility function is a measure of how
risk averse an individual is. For the xed amount gambles,
a person with a more concave utility function will be ….
risk averse.
more
Someone who is risk neutral has a …….. marginal risk utility of wealth, hence a utility function linear in wealth.
Constant
A risk neutral person will take whichever option has …….. expected value, since maximising expected value maximises …….. as well.
Higher / Utility
A risk loving or risk prone person has ……….. marginal utility of wealth, hence a convex utility function. Each dollar provides greater additional happiness than the dollar before it.
Increasing
(vNM) utility
Von Neumann-Morgenstern (vNM) utility
vNM characterised the expected utility with .. axioms: completeness, transitivity, continuity, and independence
4
Continuity means that:
Very small changes in probabilities do not change the preference ordering between lotteries.
Independence means:
If we mix two lotteries with a third one, the preference ordering of the two mixtures will not change, and is independent of the particular third lottery used.
The independence axiom is also sometimes called the ……….. axiom. The idea being that if C is substituted for part of A and part of B, this shouldn’t change my ranking
Substitution
People ………. outcomes that are considered certain, relative to outcomes which are merely probable. This phenomenon is called certainty effect (or sometimes, the Allais paradox). It was originally described by Allais in 1953.
Overweight
A closely related phenomenon to the certainty effect, also discovered by Allais, is the so called …….. …… ……
Common ratio effect
Where winning is possible but not probable, most people choose the prospect that offers the ……. gain
Larger
Changing positive prospects to negative prospects …….. the preference for most people. This is called the reflection effect.
Reverses
The reflection effect implies risk ……… in the positive domain and risk …….. in the negative domain
Aversion / Seeking
“Overweighting of ………” favours risk aversion in the domain of gains and risk seeking in the domain of losses
Certainty
