What is the distinction between descriptive and normative decisions?
descriptive:
- how we make decisions
normative:
- how we should make decisions
What does rationality refering to?
Rationality refers to:
- Preferences: how people compare two or more alternatives -> Choice under certainty
- Beliefs: the way people update their beliefs when new information arrives -> Judgement under risk and unvertainty
What is a preference?
How people compare two or more alternatives
How can you be rational/ make rational choices?
- you have a rational preference ordering
- you choose the most preffered item
Which theory is used to descirbe preferences?
Utility function
How does a uitilty funciton look like?
is the utility function ordinal or cardinal?
- ordinal
- but not cardinal
-> more is better, but the slope gets flather with increasing value.
What kind of phenomena are insconsistent with the theory of choice under certainty?
- opportunity costs
- sunk costs
- decoy effect
What are opportunity costs?
- it is the value of the most valuable alternative option
- in practice, people frequently overlook or underestimate opportunity costs
What is the sunk cost fallacy?
- people hold on to failed investment, stay in failed relationship etc.
- rational choices are completely forward-looking. things that happened in the past matter only insofar as they affect future outcomes.
What is the decoy effect?
- adding an inferior option may influence preferences
Most real-life decisions are not choices under certainty -> therefore, we need the theory of probability
What kind of attitudes towards risk do we have? (3)
- risk averse: if you would reject a gamble in favor of a sure CHF amount equal to its expected value.
- risk prone or loving: if you would accept a gamble rather than a sure CHF amount equals to its expected value.
- risk neutral: if you are indifferent between a gamble and a sure CHF amount equal to its expected value
What phenomena are inconsistent with the theory of choice under risk and uncertainty?
- Allais problem
- Ellsberg problem
What is the endowment effect?
something that we own has a bigger value for us than something we don’t
What is the expected value of a gamble?
what you expect to win on average, in the long run, when you play the gamble
What are the drawbacks of the expected value?
it is only possible to compute EV when consequences can be described in numerical terms.
What is the St. Petersburg Paradox?
The St. Petersburg Paradox is a situation in which a theoretical game has an infinitely high average payoff, but in reality, people wouldn’t pay much to play it. This happens because the huge potential winnings are very unlikely, so the average value (expected value) of the game doesn’t match what people feel is a fair price to play. This paradox shows that people’s real-life decisions about risk and reward don’t always align with mathematical expectations.
How can be the St. Petersburg Paradox be resolved?
by assuming that people maximize expected utility rather than expected value -> individual probablities
If you accept the gable your payoff looks like this (+CHF 10, 0.5; CHF 0, 0.5). If you reject, you will get CHF 4. How much is the Expected value? How much is the Expected Utility if your u(x) =Wurzel X?
Ellsberg problem: How are people according to risk, when the probabilities of potential outcomes are unknown?
People may be more risk-averse when the probabilities of potential outcomes are unknown.
Allais problem
Decisions should not be influenced by sure things
What is Framing?
Framing refers to the way information or a problem is presented to people, which can significantly influence their decisions and judgement.
-> but in EUT the decisions should not depend on how the problem is framed.
What is the prospect theory?
it describes how people make decisions involving risk and uncertainty. It contrast with the traditional expected utility theory, which assumes that people always make rational decisions to maximize expected utility.
