Lecture 4 Risk Preferences Flashcards Preview

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Flashcards in Lecture 4 Risk Preferences Deck (20)
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1
Q

What are the risk preferences of the homo economicus?

A

It obeys the principles of expected utility theory

2
Q

What is the conclusion of the paper of Bernoulli (1738)?

A

People have risk-averse preferences and therefore people maximize expected utility and not expected monetary value

3
Q

Diminishing Marginal Utility

A

The same amount of additional money is less useful to an already-wealthy person than it would be to a poor person

4
Q

Expected Utility Theory (EUT)

A

Describes how people should make decisions by means of rational computations based on objective outcomes and probabilities, without cognitive limitations and emotions

5
Q

What are the important and less important underlying principles for the EUT?

A
  1. Independence
  2. Invariance
  3. Asset integration

Completeness
Transitivity
Continuity
Reduction
Monotonicity
Risk aversion

6
Q

Invariance

A

Different representations of the same choice problem should yield the same preferences

7
Q

What are two forms of invariance and what do they mean?

A

Description invariance (how distributions are described)
Procedure invariance (method used to elicit preferences)

8
Q

Asset Integration

A

Final wealth states matter, not just prospect outcomes that means that risk preferences are affected by the size of the gamble relative to a person’s wealth

9
Q

What are two EUT violating discoveries by Maurice Allais for Independence (1953)?

A

The common Consequence effect (the “Allais Paradox”)
Common ratio effect

10
Q

The common Consequence effect (the “Allais Paradox”)

A

A common consequence effect (CCE) occurs if the preference between two lotteries changes if the same probability mass is shifted from one common outcome to a different common outcome in both lotteries.

11
Q

Common ratio effect

A

The effect that people tend to choose more for a certain amount lower than a higher expected value.

12
Q

What is a third violation of the EUT rule of invariance, the asian disease?

A

The framing effect (framing the question different will effect the answer)

13
Q

What does the fourth violation of EUT of Rabin’s Critique entails?

A

The bigger the amount we can lose, the more risk averse we become. plausible risk-aversion at small
stakes implies implausible risk-aversion at large stakes to lose.

14
Q

Prospect Theory

A

The gain/loss framing is the cornerstone. People will tend choose more for a gain than a loss even the situation is the same

15
Q

Certainty effect

A

A reduction of the probability of an outcome by a constant factor has more impact on the decision weight when the outcome was initially certain than when it was merely probable.

16
Q

What are the two steps of the prospect theory?

A

Editing phase (coding outcomes as gains and losses)
Evaluating phase (Overweight small probabilities, weigh function & Loss aversion, value function on outcomes)

17
Q

Mental Accounting

A

The set of cognitive operations (“mental rules”) that people use to organize, evaluate and keep track of financial activities

18
Q

What are the three components of Thaler (1999)

A

cost-benefit analysis
Assignment of activities to specific accounts
Evaluation frequency

19
Q

Narrow framing

A

tendency to consider choice problems in isolation

20
Q

Myopic loss aversion

A

combination of narrow framing and loss aversion