Week 2: Decisions Under Uncertainty

Question 1

What is behavioral economics?

Answer 1

• A method of economic analysis that applies psychological insights into human behavior to explain decision making

Question 2

What is expected utility theory?

Answer 2

• Expected utility theory states that if a person’s preferences can be represented by an expected utility function all we need in order to know his preferences over uncertain outcomes are his payoffs from certain outcomes.

Question 3

State and explain the four required axioms for the expected utility theory

Answer 3

1, Completeness: For any lotteries X and Y either X>Y Y>X or X and Y are indifferent

2. Transitivity: If X>Y and Y>Z then X>Z
3. Continuity: If X>Y>Z, then the agent is indifferent between Y and some weighted average of X and Z. For example given a good medium and bad lottery you can find the weighted average of a good and bad one, the medium one.
4. Independence: The preferences of two lotteries are not affected by mixing a third in

Question 4

Example of Expected Utility Theory

Answer 4

• Check notes

Question 5

Alias paradox

Answer 5

Question 6

Ellsberg Paradox

Answer 6

• It is thought that betting for or against known information is safer than betting for or against the unknown information
• Ellsberg describes this by saying people dislike ambiguity or ambiguity aversion
• Ambiguity can be described as uncertainty about probability created by missing information that is relevant and could be known.

Question 8

Framing Effect

Answer 8

• Preferences are pre-convinced but simple changes to the presentation can cause huge changes

Question 9

Prospect theory and what the two scales mean

Answer 9

• A prospect is something is like a lottery which has a probability distribution
• The value prospect V, is expressed in terms of 2 scales: (1) The Value Function v(x) and weighting function Pie(p)
• v assigns to each outcome (x) a number v(x) which reflects the value of that outcome.
• Pie associates with each probability p a decision weight Pie(P), which reflects the impact of p on the overall value of the prospect. Pie is the weight of the outcome i.e how it affects it and p is the probability that this happens.

Question 10

Prospect theory value function and reasons why the value function is shaped in that way

Answer 10

Question 11

Prospect Theory weighting function and the two main principles behind it

Answer 11

1. Reference dependence: This is the idea that individuals tend to overweight low probabilities and underweight very high probabilities.
2. Diminishing Sensitivity: This is the idea that as you move away from points you will be less sensitive to probability changes.

Question 12

Endowment effect Kahneman, Jnetsch & Thaler (1990)

Answer 12

Question 13

Equity premium puzzle

Answer 13

• Investors are not averse to the variability of returns on the stock market, they are averse to loss (the chance that there are negative returns)
• Therefore because of risk aversion individuals are likely to prefer annual bond returns because there is less chance they will lose money due to it being much safer.
• Stocks are known in the long horizon to increase so we must assume individuals look at the short horizon.
• Two factors contribute to an investor being unwilling to bear the risks associated with holding equities: Loss aversion and myopic loss aversion.

Question 14

Disposition effect

Answer 14

• Tendency to hold losses and sell gains
• Purchase price of a stock should not determine the price you sell it at
• Assets sold for profit = realised gains
• Assets that could of been sold for profit = paper gains and same principle with losses