Behavioural Economics and EUT
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Questions and Answers

What is the principle that suggests people react more strongly to negative outcomes compared to positive outcomes?

  • Nonlinear preferences
  • Loss aversion (correct)
  • Risk aversion
  • Expected utility theory

    • Which concept explains why individuals may pay more to reduce a high-risk situation than to minimize a low-risk situation?

  • Risk aversion
  • Nonlinear preferences (correct)
  • Expected utility theory
  • Behavioral anomalies

    • Which phenomenon describes the tendency to overvalue small probabilities and undervalue large probabilities?

  • Loss aversion
  • Availability heuristic (correct)
  • Risk perception
  • Nonlinear preferences

    • In the context of behavioral economics, what does nonlinear transformation of the probability scale imply?

    <p>Individuals respond to probabilities in a nonlinear manner</p> Signup and view all the answers

    How does the example of Russian roulette illustrate nonlinear preferences?

    <p>It explains the greater concern for reducing risk from higher bullets</p> Signup and view all the answers

    What is the primary distinction of Prospect Theory from Expected Utility Theory?

    <p>It includes a two-stage process with editing and evaluation.</p> Signup and view all the answers

    In the context of Prospect Theory, how are outcomes defined?

    <p>In terms of gains and losses relative to a reference point.</p> Signup and view all the answers

    Which of the following is a violation associated with Expected Utility Theory as discussed in the content?

    <p>Framing effects</p> Signup and view all the answers

    What does the 'editing' phase in Prospect Theory primarily involve?

    <p>Organizing and structuring choices before evaluation.</p> Signup and view all the answers

    Which behavioral anomaly is highlighted in the content as being a key component of Prospect Theory?

    <p>Loss aversion</p> Signup and view all the answers

    What is a characteristic of a risk-averse individual?

    <p>They reject a gamble for a sure amount equal to the expected value.</p> Signup and view all the answers

    What causes risk aversion according to Expected Utility Theory?

    <p>Concavity of the utility function</p> Signup and view all the answers

    What is the mathematical form of the utility function in Expected Utility Theory for a risk-averse individual?

    <p>u = xb, where b &lt; 1</p> Signup and view all the answers

    What principle explains why risk aversion occurs?

    <p>Law of diminishing marginal utility</p> Signup and view all the answers

    Which of the following best illustrates risk-seeking behavior?

    <p>Accepting a high-risk investment for higher potential returns</p> Signup and view all the answers

    What effect does the concavity of the utility function have on individual preferences?

    <p>Promotes risk-averse decisions</p> Signup and view all the answers

    How does diminishing marginal utility relate to risk aversion?

    <p>It decreases the attractiveness of additional wealth.</p> Signup and view all the answers

    An individual is considered risk neutral if they would prefer which of the following?

    <p>A gamble with a 50% chance of $1000.</p> Signup and view all the answers

    Which formula represents the expected value of option A?

    <p>V(A) = (0.9×0)+(.06×45)+(.01×30)+(.01×−15)+(.02×−15)</p> Signup and view all the answers

    What is the expected utility of option B?

    <p>2.75</p> Signup and view all the answers

    What concept explains the tendency of individuals to prefer certain gains over probabilities of higher gains?

    <p>Loss Aversion</p> Signup and view all the answers

    In the context of Prospect Theory, what are the two main stages of decision-making?

    <p>Editing and Evaluation</p> Signup and view all the answers

    How does Expected Utility Theory suggest decision-makers behave?

    <p>Maximize the utility of the chosen outcome</p> Signup and view all the answers

    Which of the following best describes 'nonlinear preferences' in the context of decision-making?

    <p>Preferences that do not consistently correlate with perceived risk</p> Signup and view all the answers

    What does the term 'editing' refer to in Prospect Theory?

    <p>The initial analysis of possible outcomes</p> Signup and view all the answers

    Which choice represents a risk-seeking behavior?

    <p>Accepting a gamble for a 50% chance to win $100</p> Signup and view all the answers

    What does a prospect consist of in decision making under risk?

    <p>A number of possible outcomes and their associated probabilities</p> Signup and view all the answers

    How can Prospect A, with a 50% chance to win 100 and a 50% chance to win nothing, be formally represented?

    <p>(100, 0.5; 0, 0.5)</p> Signup and view all the answers

    What does loss aversion refer to in behavioral economics?

    <p>The preference to avoid losses more than acquiring equivalent gains</p> Signup and view all the answers

    Which of the following best describes risk aversion?

    <p>Seeking sure gains instead of uncertain gains</p> Signup and view all the answers

    What does Prospect Theory explain in relation to decision making?

    <p>How individuals make decisions when facing uncertainty</p> Signup and view all the answers

    What is a characteristic of anomalies in Expected Utility Theory (EUT)?

    <p>They reveal patterns inconsistent with traditional utility expectations</p> Signup and view all the answers

    What does nonlinear preferences in behavioral economics imply?

    <p>Different outcomes are perceived differently based on their context</p> Signup and view all the answers

    In decision theory, what does the evaluation process in Prospect Theory primarily involve?

    <p>Assessing potential outcomes through a nonlinear lens</p> Signup and view all the answers

    What is the primary reason people experience loss aversion?

    <p>Losses have a longer-lasting emotional impact than gains</p> Signup and view all the answers

    How does loss aversion typically manifest in trading behavior in the stock market?

    <p>Higher trading volume during increasing prices</p> Signup and view all the answers

    Which concept explains why people may choose risky options instead of conservative ones?

    <p>Risk seeking</p> Signup and view all the answers

    What role does the reference point play in loss aversion?

    <p>It serves as a basis for determining gains and losses</p> Signup and view all the answers

    In which instance would a person exhibit loss aversion when making a choice?

    <p>Deciding not to sell a stock that has decreased in value</p> Signup and view all the answers

    What theory incorporates loss aversion and provides insights into decision-making under risk?

    <p>Prospect Theory</p> Signup and view all the answers

    What is a common outcome of loss aversion in financial markets during downturns?

    <p>Reduced trading activity due to reluctance to incur losses</p> Signup and view all the answers

    Study Notes

    Behavioural Economics

    • Behavioural economics examines how psychological factors influence economic decision-making.
    • It contrasts with traditional neoclassical economics that assumes rational actors.
    • Behavioural economics considers that people are not always rational and that their decisions are influenced by factors like cognitive biases and emotional responses.

    Expected Utility Theory (EUT)

    • EUT is a standard economic model that examines preferences, beliefs and utility maximization.
    • It postulates that people make decisions to maximize their expected utility.
    • EUT uses axioms of completeness and transitivity to evaluate preferences.
    • The axioms are based on von Neumann and Morgenstern's work (1947).
    • This theory assumes preferences are independent and that people are rational in choosing preferences.

    Anomalies in EUT

    • Observed behaviour often deviates from predictions under EUT.
    • EUT assumes individuals are risk-averse.
    • Behavioural evidence suggests individuals are more complex, and exhibit risk-aversion preferences or risk-seeking preferences in certain situations.
    • One example is people's reactions to gambles and lottery prizes.

    Prospect Theory

    • Prospect theory is an alternative to EUT, designed to explain observed anomalies.
    • This theory posits that people evaluate their choices based on gains and losses, not overall wealth.
    • It defines people's attitude toward gain/loss/risk as affected by certain reference points.
    • Prospect theory acknowledges that people weigh gains and losses differently and are influence by perceived losses or gains.
    • The theory's two-stage evaluation process distinguishes it from EUT.
    • Its editing phase factors in features and simplifications of choices, making it a distinct process from EUT.

    Loss Aversion

    • Individuals feel losses more strongly or intensely than equivalent gains.
    • Individuals are averse to potential losses and may take actions that avoid loss.
    • Loss aversion is a key prediction and factor that prospect theory highlights.

    Risk Aversion

    • Individuals prefer a sure outcome to a gamble with the same expected value.
    • This contrasts with risk seeking preferences, where individuals are attracted to gambles.
    • Risk aversion can be defined by a utility function.
    • Individual preferences toward risk-aversion can be influenced by gain/loss, framing, or probability.

    Risk Seeking

    • Individuals prefer a gamble to a sure outcome when facing potential losses.
    • This contrasts with risk aversion where individuals favor a sure outcome over a gamble with the comparable expected value.
    • Individuals are influenced by loss functions when deciding on how they approach gambles and lotteries.

    Non-Linear Preferences

    • People do not always evaluate decisions in a linear manner (e.g., multiplying gains or losses by probabilities).
    • Their preferences and choices towards probabilities do not follow neat or linear mathematical models.
    • Their reaction to probabilities are non-linear, influenced by decision weighting, and are distinct from the linear predictions offered by EUT.

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    Related Documents

    Behavioural Economics, PSYC3310, Seminar 5, PDF

    Description

    This quiz explores the principles of behavioural economics and the Expected Utility Theory (EUT). It highlights how psychological factors influence economic decisions, contrasting with traditional economic models. Additionally, it addresses the anomalies observed in EUT, emphasizing the deviations from rational choice assumptions.

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