Behavioural Economics 3: Choice under Uncertainty 3.1 - Expected Utility Theory Flashcards
(8 cards)
Importance of studying choice under uncertainty
Many economic decisions involve uncertainty — outcomes depend on unknown future events. Understanding how people make such decisions is crucial for:
Modelling behaviour: e.g., charitable giving, investment, job changes.
Policy design: e.g., resource allocation, insurance, regulation.
Examples:
Buying a beach drink license: profitable in hot summers, not in cold ones.
Investing in oil: payoff depends on discovering new fields.
Accepting a job: outcome depends on which manager you work with.
These decisions must be made before the realisation of a random variable, making uncertainty central to economic analysis.
What is the difference between risk and ambiguity in decision-making?
Uncertainty: Outcomes depend on probabilities rather than being certain.
Risk: Probabilities are known.
E.g., Tossing a fair coin (p = ½), rolling a die (p = 1/6).
Ambiguity: Probabilities are unknown.
E.g., Drawing a red ball from an urn with unknown composition.
Getting a bonus if R&D succeeds.
Winning money if your sports team wins the league.
⚠️ Note: Some people use “uncertainty” to mean “ambiguity,” but in this context, uncertainty includes both risk and ambiguity.
What are prospects, consequences, and probabilities in choice under risk?
How are preferences over prospects represented in decision theory?
How is expected value (EV) used to evaluate prospects under risk?
What is the St. Petersburg Paradox and what does it reveal about expected value?
What is Expected Utility Theory and how does it improve on Expected Value?
Expected Utility: outfit choice example
