Topic 3 - Part 1: Decision Making Under Risk & Uncertainty

Question 1

What theory has dominated economic analysis of choice under risk and uncertainty?

Answer 1

Expected Utility Theory (EUT).

Question 2

In EUT, how are choices evaluated?

Answer 2

By maximizing expected utility rather than expected value.

Question 3

What is a “prospect” in the context of decision-making under risk?

Answer 3

A contract that yields specific outcomes with assigned probabilities.

Question 4

The (riskless) prospect that yields x with certainty is
denoted by:

Answer 4

(x)

Question 5

Define Expected Utility

Answer 5

It is the probability-weighted average of utility values from potential outcomes (e.g. utility of monetary values).

Question 6

Define Expected Value

Answer 6

The expected value (EV) of a prospect is the value of each possible outcome times the probability of that outcome

Question 7

People do not seek to maximise expected values, but
instead seek to maximise ……….. ……..

Answer 7

expected utility

Question 8

What does a concave utility function indicate?

Answer 8

Risk aversion

Question 9

How does risk aversion affect choices between risky and certain prospects?

Answer 9

Risk-averse individuals prefer certain outcomes over risky ones with equal or higher expected value.

Question 10

What is “asset integration” in EUT?

Answer 10

A prospect is acceptable if it increases the utility of a person’s assets.

Question 11

How do risk-neutral individuals make decisions under risk?

Answer 11

They select the option with the highest expected value.

Question 12

Diminishing marginal utility implies that the utility of the certain wealth is …….. than risky wealth.

Answer 12

higher

Question 13

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.

Answer 13

more