Week 1 - Choice Under Uncertainty Flashcards
What does rationality impose on an individual?
Rationality imposes on an individual that they have internally consistent preferences and they do not exhibit naive behaviour which can be exploited in a game.
Briefly state and explain the 2 preferences that make an individual rational
- Completeness - Able to rank and compare different bundles.
- Transitive - This means that with 3 choices A B C if A>B and B>C then transitivity occurs If A>C
State the 5 properties of preferences
- Completness
- Transitivity
- Monotonicity
- Convexity
- Continuity
Explain the preference monotonicity
This is the idea that more is always better, and is the reason scarcity exists
Explain the preference convexity
Convexity is the idea that averages are better than extremes, preferences are convex to the origin. This is a general observation that individuals prefer diversity.
Explain the preference continuity
Continuity is the idea that utility does not change dramatically if a conumed bundle changes only slightly. For example adding 1 less drop of milk will will have a very small effect on consumption.
What is the bliss point?
The bliss point is a quantity of consumption where any further increase would make the consumer less satisfied. It is a quantity of consumption which maximizes utility in the absence of budget constraint
What is the expected utility theorem?
A utility function over any lottery can be written as the expected utility of the outcomes that make up this lottery.
What behaviour do risk averse individuals exhibit?
- They have a a concave utility function, the more risk averse the more concave the function is.
- The Expected utility of the lottery Eu(L), is less than < the utility from the expected lottery uE(L).
What behaviour do risk loving individuals exhibit?
- They have a convex utility function.
- The expected utility from the lottery Eu(L) is greater than > the utility from the expected lottery uE(L)
What is the certainty equivalence, what is it equal to and what is the risk premium?
- The certainty equivalence is the sure amount of money you are willing to accept instead of a lottery.
- U(C)=Eu(L), the utility of the certainty equivalence = the expected utility of the lottery.
- For risk averse people the sure amount of money you are willing to accept instead of a gamble is less than the expected amount of money that you would get from the gamble.
- The risk premium = E(L) -C(certainty equivalence), the individual will accept less for a sure amount to avoid the risk.
How do we measure risk aversion, and what does the value tell us?
- Ra(W)=- U’‘(W)/U”(W), this is knows as the arrow-prat measure of absolute risk aversion.
- A positive value = individual is risk averse, a negative value= individual is risk loving.
How do we measure relative risk aversion and why is it useful?
- Rr= - U’‘(W).W/U’(W)
- It is useful, because even if the utility function changes from risk averse to risk loving individuals, so it still gives a valid measure of risk aversion even though the utility is not strictly convex or concave.
