Topic 5: Choice under Uncertainty

Question 1

expected utility model

Answer 1

most commonly used model under uncertainty

Question 2

goal of choice under uncertainty

Answer 2

model of the choice of an individual faced with actions whose consequences are uncertainty

Question 3

lotteries

Answer 3

probability distribution where DM faces a choice among risky alternatives

Question 4

consequentialism

Answer 4

only the reduced lottery over final outcomes matters to the DM

Question 5

allais paradox

Answer 5

mathematically impossible statements and cannot simultaneously be true

these types of violations are not rare

1 - choose between A with 2500 with probability 0.33, 2400 with probability 0.66 and 0 with probability 0.01 or B with 2400 certainty

2- choose between C with 2500 with probability 0.33, 0 with probability 0.66 and 0 with probability 0.01 or C with 2400 with probability 0.34 and 0 with probability 0.66

people choose the modal response in both questions which is an allais violation

Question 6

validity of the model of choice under uncertainty

Answer 6

not all people in experiments display these preferences
- not one size fit all

do we have the right idea of what final consequences/outcomes are?
- semantics of journey vs. decision

learning from one’s mistakes

is the contradiction too stylised?

Question 7

ellsberg paradox

Answer 7

300 balls - 100 red, 200 either blue or green

1 - receive 1000 if the ball is red, else nothing
2 - receive 1000 if the ball is blue, else nothing

vast majority pick the first option but with expected utility it doesn’t make sense

second option is ambiguous and people systematically dislike ambiguity
- can’t use the model to describe the individual

Question 8

allais vs. ellsberg

Answer 8

allais pushes us to consider how the DM values objects

ellsberg invites us to consider how the DM perceives probabilities

Question 9

machina’s paradox

Answer 9

point is that we experience feelings

Question 10

framing

Answer 10

outbreak causes 600 diseases

1 - choose between 200 saved with A, or 600 saved with 1/3 probability and 0 saved with 2/3 probability with B
2 - chosen between 400 deaths with C, or 0 deaths with 1/3 probability and 600 deaths with 2/3 probability

choices are identical but people tend to choose A over B and D over C

mindset of thinking about losses/gains can change your decision

Question 11

certainty equivalent

Answer 11

amount of money that leaves DM indifferent between money and the gamble

smaller than the gamble’s expected amount

Question 12

insurance premium

Answer 12

paying someone to absorb the risk when risk premium is positive

Question 13

degree of risk aversion

Answer 13

how curved the bernoulli function is
- the more curved, the willingness to pay to avoid risk goes up

straight line means individual is risk-neutral and indifferent between risk of getting 0 or a lot, and getting the average for certain

Question 14

absolute risk aversion

Answer 14

allows for the possibility of different degrees of risk aversion depending on the amount of money there is

measures of curvature for the bernoulli curve

Question 15

relative risk aversion

Answer 15

unit measure of risk aversion normalising for amount of wealth

attitudes towards gambles of a fraction of total wealth (and not of a particular amount)

Question 16

absolute vs. relative risk aversion

Answer 16

absolute risk aversion when thinking about gambles of a particular dollar amount

relative risk aversion when thinking about gambles of a particular proportionate amount

Question 17

constant absolute risk aversion utility function

Answer 17

risk aversion doesn’t depend on income/amount

useful but typically not true