decision under risk

Question 1

Hard core

Answer 1

people are rational (transitivity and completeness)

Question 2

Physchological assumptions of neoclassical economics

Answer 2

• Costlessly process information
• Bayesian probability operators. A way of determining payoff from pre determined probabilities.
• Discount time exponentially
• Are governed by selfish concerns.
  Maximise expected utility

Question 3

What does ‘as if’ mean

Answer 3

Economic theory shouldn’t be judged on the realism of its assumptions but on how well the predictions of the theory explain behaviour. Ronnie O’sullivan example.

Question 4

Evaluating theories

Answer 4

• Congruence with reality
• Generality
• Tractability
• Parsimony

Question 5

Advantages of experiments

Answer 5

Control you have in a lab, instruct, set up incentives. Can recreate ‘ceteris paribas’

Question 6

Disadvantages of experiments

Answer 6

Hawthorne effect - where subjects behave differently inside a lab

Question 7

Axioms of EUT

Answer 7

• Rationality (completeness and transitivity)
• Continuity
• Independence - assumed to be preferred at all different ratios

Question 8

Allais paradox

Answer 8

Shows that a common consequence violates the independence axiom

Question 9

common consequence

Answer 9

When something is added to both options

Question 10

Reflection effect

Answer 10

People have different risk preferences between positive and negative outcomes. +ve = risk averse. -ve = risk taker

Question 11

Isolation effect

Answer 11

Where the individual lightens the cognitive load

Question 12

How to eliminate event splitting effect

Answer 12

Use stripped down prospect theory hence W(0.3) + W(0.3) may not equal W(0.6)

Question 13

Assumptions in the editing process

Answer 13

Coding assumption
Combination assumption
Segregation assumption
Cancellation

Question 14

Properties of the value function

Answer 14

Loss aversion
Diminishing sensativity
Reference point

Question 15

Loss aversion

Answer 15

Losses are larger than gains. Disposition effect in the stock market - people hold onto stocks that lose value and eager to sell gains.

Question 16

Diminishing sensitivity

Answer 16

Marginal utility falls as we move further away from the reference point. Risk averse preferences over gains and risk loving preferences over losses.

Question 17

Reference point

Answer 17

V(0) = 0. Outcomes judged in terms of gains and losses. ‘Happiness treadmill’ like winning the lottery, it’s all about expectation.

Question 18

Weighting function characteristics

Answer 18

• w(0) = 0 and w(1) = 1
• increasing in p
• Not defined close to zero and one.
• Subproportionality
• overweighting
• sub certainty

Question 19

According to prospect theory, gains loom larger than gains. True or false

Answer 19

False

Question 20

According to prospect theory, the probability weighting function can be decreasing in the objective probability p. True or false

Answer 20

False

Question 21

According to prospect theory, small probabilities tend to be underweighted. True or false

Answer 21

False

Question 22

Prospect A: (£10,1)

Prospect B: (£50,0.1; £10,0.89; £0,0.01) under expected utility

Answer 22

U(10) = 0.1U(50) + 0.89U(10)
0.11(10) = 0.1U(50)

Question 23

Prospect A: (£10,1)

Prospect B: (£50,0.1; £10,0.89; £0,0.01) under prospect theory

Answer 23

w(1)V(10) = w(0.1)V(50) + w(0.89)V(10)

V(10) = w(0.1)V(50) + w(0.89)V(10)

subtract w(0.89)V(10) from both sides.

{1-w(0.89)}V(10) = w(0.1)V(50)

Question 24

Prospect theory can resolve Allais’ paradox when preferences satisfy what?

Answer 24

Subcertainty

Question 25

The independence axiom is that a common consequence added to all lotteries will not change choice behaviour. True or false

Answer 25

True

Question 26

A risk averse person will refuse a fair gamble. True or false

Answer 26

True

Question 27

A difficulty with testing economic theory in laboratories is that the ceteris paribus assumption cannot be made to hold

Answer 27

False

Question 28

According to the levels puzzle, empirically observed levels of tax compliance are too low to be accounted for by expected utility theory. True or false

Answer 28

False - observed levels are too high

Question 29

In the standard tax compliance model (as in lecture notes) a taxpayer is fined on all undeclared income at the rate F > 0 if caught evading . true or false

Answer 29

False - F in practice is between 0.1 and 1.

Question 30

The overweighting of small probabilities under prospect theory helps to resolve the levels puzzle. True or false

Answer 30

True

Question 31

Event-splitting effects are consistent with the prospect theory assumption of loss aversion. True or false

Answer 31

False - event splitting can only be resolved by using stripped down prospect theory.

Question 32

Segregation in the editing phase of prospect theory can account for the isolation effect

Answer 32

True

Question 33

If lottery A can be built from lottery B by moving some of the probability weight in B towards a better outcome, then B stochastically dominates A

Answer 33

False