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Questions and Answers
What is a key feature that allows prospect theory to address the Allais paradoxes?
What is a key feature that allows prospect theory to address the Allais paradoxes?
Which phenomenon does prospect theory explain through loss aversion?
Which phenomenon does prospect theory explain through loss aversion?
How does prospect theory address the Ellsberg paradox?
How does prospect theory address the Ellsberg paradox?
What aspect does the reflection effect in prospect theory illustrate?
What aspect does the reflection effect in prospect theory illustrate?
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Which statement about prospect theory is most accurate?
Which statement about prospect theory is most accurate?
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What does probabilistic insensitivity refer to in prospect theory?
What does probabilistic insensitivity refer to in prospect theory?
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Which theory asserts that individuals make decisions based primarily on perceived gains and losses?
Which theory asserts that individuals make decisions based primarily on perceived gains and losses?
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What is the implication of state-dependent reference points in prospect theory?
What is the implication of state-dependent reference points in prospect theory?
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What does EUT stand for in the context of decision-making theories?
What does EUT stand for in the context of decision-making theories?
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What significant choice pattern did Allais observe in his experiments?
What significant choice pattern did Allais observe in his experiments?
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In Ellsberg's paradox, which situation demonstrates the violation of expected utility theory?
In Ellsberg's paradox, which situation demonstrates the violation of expected utility theory?
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Why can expected utility theory be considered violated according to the Allais and Ellsberg paradoxes?
Why can expected utility theory be considered violated according to the Allais and Ellsberg paradoxes?
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What is a key characteristic of the urns described in Ellsberg's example?
What is a key characteristic of the urns described in Ellsberg's example?
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What psychological factor was suggested to influence the choices observed in the Allais paradox?
What psychological factor was suggested to influence the choices observed in the Allais paradox?
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What was the central focus of Ellsberg's 1961 paper regarding expected utility theory?
What was the central focus of Ellsberg's 1961 paper regarding expected utility theory?
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What outcome would a participant achieve in Ellsberg's experiment if they chose the correct color from the urn?
What outcome would a participant achieve in Ellsberg's experiment if they chose the correct color from the urn?
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What is the term used to describe a preference for known probabilities over unknown probabilities?
What is the term used to describe a preference for known probabilities over unknown probabilities?
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What paradox arises when probabilities in the unknown urn sum to less than one?
What paradox arises when probabilities in the unknown urn sum to less than one?
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Which axiom of Expected Utility Theory (EUT) is primarily violated by ambiguity aversion?
Which axiom of Expected Utility Theory (EUT) is primarily violated by ambiguity aversion?
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If the known-proportion urn yields a higher perceived probability of drawing a specific color, what does that imply about the unknown-proportion urn?
If the known-proportion urn yields a higher perceived probability of drawing a specific color, what does that imply about the unknown-proportion urn?
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What does the expression $p_{ru} + p_{gu} < p_{rk} + p_{gk}$ signify?
What does the expression $p_{ru} + p_{gu} < p_{rk} + p_{gk}$ signify?
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Which of the following describes the violation of the transitivity axiom in decision making?
Which of the following describes the violation of the transitivity axiom in decision making?
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When decision makers display preference for the known-proportion urn, which of the following can be inferred?
When decision makers display preference for the known-proportion urn, which of the following can be inferred?
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Which outcome is more likely due to preference reversals?
Which outcome is more likely due to preference reversals?
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Study Notes
Advanced Primer in Decision Theory
- Decision theory studies individual decision-making processes, and applies to various fields, including economics and psychology
- Expected utility theory (EUT) is a core concept: It's essential for modeling decision-making under risk.
- EUT has shortcomings as a descriptive theory: it doesn't accurately reflect observed human behavior under risk
- Alternative models like rank-dependent models and prospect theory attempt to improve upon EUT's shortcoming
Risk Preferences
- Decision theory uses prospects over uncertain outcomes, often monetary, to study decision-making
- Risk, in the context of decision theory, signifies situations where probabilities are known or knowable, like state lotteries
- Descriptive theories aim to represent actual decision-making patterns, while normative theories prescribe ideal behaviors, such as maximizing utility
- Expected Value Theory (EVD) is a simple theory based on mathematical expectation to predict a choice, but doesn't account for risk aversion, where people often prefer a guaranteed smaller prize rather than a potentially larger prize
Expected Utility Theory
- A normative model where an individual's decisions are driven by maximizing the expected utility of a prospect
- Introduces subjective utility function U(ξ) that transform prospects or outcomes based on their utility. The utility of a certainty equivalent equals the expected utility of a prospect
- Utility functions are unique up to a positive linear transformation. These theories are good for certain applications but don't account for all aspects of human decision-making.
EUT as a Descriptive Theory of Choice
- EUT presents a good normative theory of decision-making. However, it doesn't adequately describe observed decision patterns
- It has shortcomings: Notably, people display risk aversion, especially with smaller amounts of money, contradicting the predictions of EUT and the use of concave utility function.
- Preference reversals, where people exhibit different preferences when choosing versus stating a price, add to EUT's weaknesses
Empirical Violations of EUT
- The Allais paradox highlights that individuals' preferences can violate EUT assumptions, particularly concerning the ratio of outcomes in choices
- The Ellsberg paradox demonstrates ambiguity aversion: individuals exhibit preference reversals even when they don't know the probabilities involved.
Prospect Theory
- It's a model used in decision-making theory that suggests that people make decisions based on perceived gains and losses rather than final outcomes
- It introduces a value function v(x) and weighting function w(p) that are nonlinear for both losses and gains that reflect loss aversion
- Framing effects, where identical outcomes from the same decision presented in different ways can affect choices
Uncertainty and Ambiguity
- Uncertainty refers to situations where probabilities aren't known, unlike risk where probabilities are known.
- Ambiguity refers to situations where the probabilities of events are unknown and cannot be meaningfully estimated.
Time Preferences
- Time preference is a concept in decision theory where individuals consider the value of rewards obtained at different points in time, often reflecting that earlier rewards have a higher value than later ones
- The literature on time preferences is similar to models of risk, exhibiting similar violations
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Description
Explore the intricate concepts of decision theory, focusing on expected utility theory and its critiques. Learn about alternative models like prospect theory that aim to better explain human behavior under risk. This quiz covers essential frameworks and theories applicable in various fields such as economics and psychology.
