What are the risk preferences of the homo economicus?

It obeys the principles of expected utility theory

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

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

Diminishing Marginal Utility

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

Expected Utility Theory (EUT)

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

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

- Independence
- Invariance
- Asset integration

Completeness

Transitivity

Continuity

Reduction

Monotonicity

Risk aversion

Invariance

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

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

Description invariance (how distributions are described)

Procedure invariance (method used to elicit preferences)

Asset Integration

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

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

The common Consequence effect (the “Allais Paradox”)

Common ratio effect

The common Consequence effect (the “Allais Paradox”)

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.

Common ratio effect

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

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

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

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

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.

Prospect Theory

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

Certainty effect

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.

What are the two steps of the prospect theory?

Editing phase (coding outcomes as gains and losses)

Evaluating phase (Overweight small probabilities, weigh function & Loss aversion, value function on outcomes)

Mental Accounting

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

What are the three components of Thaler (1999)

cost-benefit analysis

Assignment of activities to specific accounts

Evaluation frequency

Narrow framing

tendency to consider choice problems in isolation

Myopic loss aversion

combination of narrow framing and loss aversion