Economic Decision-Making Concepts

Podcast

Play an AI-generated podcast conversation about this lesson

Questions and Answers

What is the expected value of a lottery ticket that pays out £10 with probability 0.5 and £0 otherwise?

£10

£5 (correct)

£7

£3

If an agent is risk-averse, what is their likely preference regarding lottery tickets and expected values?

They are indifferent between both options.

They prefer the expected value to the lottery ticket. (correct)

They prefer the lottery ticket over its expected value.

They only purchase lottery tickets with no regard to expected value.

In an expected utility framework, which statement is true?

Expected utility considers only the monetary value of outcomes.

Expected utility assesses the utility derived from outcomes rather than their raw values. (correct)

Expected utility is the same as expected value.

Expected utility does not account for individual risk preferences.

What scenario illustrates a risk-seeking behavior?

Selecting a ticket that offers a small chance of a large win over a larger guaranteed win. Signup and view all the answers

Why might experimental results show inconsistency in choices between different lottery ticket scenarios?

Due to variations in individuals' utility functions and attitudes toward risk. Signup and view all the answers

What does the reservation wage represent?

The minimum wage that an individual will accept for a job Signup and view all the answers

In which situation is a probability considered objective?

Playing roulette Signup and view all the answers

What differentiates risk from uncertainty?

Risk has known probabilities, while uncertainty has unknown probabilities. Signup and view all the answers

What does Expected Utility Theory help to model?

Decisions under uncertainty Signup and view all the answers

What is a fair bet in the context of expected value?

A bet where the expected value is equal to zero Signup and view all the answers

When is an individual likely to accept a job offer based on the reservation wage?

When the offer wage exceeds the reservation wage Signup and view all the answers

Which of the following describes subjective probabilities?

Probabilities that differ based on individual beliefs Signup and view all the answers

Which scenario exemplifies a corner solution in labor supply?

Choosing not to work when the offered wage is below the reservation wage Signup and view all the answers

What characterizes an individual with decreasing marginal utility?

They are risk-averse. Signup and view all the answers

What does 'certainty equivalent' refer to in the context of risk?

The guaranteed amount from a risky situation. Signup and view all the answers

What is the risk premium in decision-making related to risk?

The amount willing to be paid to avoid risk. Signup and view all the answers

How are risk-neutral individuals characterized in relation to their utility function?

They have constant marginal utility of income. Signup and view all the answers

Which option exemplifies the behavior of a risk-averse individual?

They prefer guaranteed income over potential gamble outcomes. Signup and view all the answers

What happens to the utility from additional income for someone with decreasing marginal utility?

It decreases as income rises. Signup and view all the answers

In expected utility maximization, what does 'EU' represent?

The expected utility from a risky choice. Signup and view all the answers

If an individual's current wealth is $w0$ and they have a certainty equivalent of $wc$, what does this imply if they are risk-averse?

Their wealth is more than their certainty equivalent. Signup and view all the answers

Study Notes

Expected Utility Theory

Expected utility theory is a framework for decision-making under uncertainty.
Individuals are assumed to be expected utility maximisers, meaning they choose the action that maximises their expected utility.
The expected utility of an action is calculated by weighting the utility of each possible outcome by its probability.

Labour Supply and Corner Solutions

Corner solutions in labour supply occur when the marginal rate of substitution (MRS) between leisure and consumption is greater than the real wage.
This means individuals are willing to sacrifice more consumption to have an extra hour of leisure than the real wage would compensate them for.
The MRS is equal to the real wage in optimum decisions.

Reservation Wage

The reservation wage is the minimum wage an individual is willing to accept for a job.
It represents the wage at which an individual is indifferent between working and not working.
The reservation wage is determined by the condition MRS = W_res.

Risk vs. Uncertainty

Risk involves known probabilities of outcomes, while uncertainty involves unknown probabilities.
The classic example of a risk situation is a roulette wheel, where the probabilities of the outcomes are known and agreed upon.
Horse races, in contrast, represent a situation of uncertainty, because the probabilities of different horses winning are subjective and vary between individuals.

Attitudes to Risk

A fair bet involves an equal probability of winning or losing an amount. The expected value of a fair bet is zero.
Individuals can exhibit risk aversion, risk neutrality, or risk-seeking behaviours.
Risk averse individuals prefer the certainty of a smaller expected payout to a lottery with a larger but uncertain expected payout.
Risk-neutral individuals are indifferent to risk and base their decisions solely on expected value.
Risk-seeking individuals prefer a lottery with a larger but uncertain expected payout to a smaller certain payout.

Expected Value vs. Expected Utility

The expected value of a risky prospect is the weighted sum of the possible outcomes, weighted by their probabilities.
The expected utility of a risky prospect is the weighted sum of the utilities associated with the possible outcomes, weighted by their probabilities.

Decreasing Marginal Utility

Marginal utility is the added utility one derives from an additional unit of consumption.
Decreasing marginal utility means that the additional utility derived from each additional unit of consumption decreases as consumption increases.

Different Possible Risk Attitudes

Attitudes to risk can be characterised by marginal utility decreasing, constant or increasing. - Decreasing marginal utility leads to risk aversion - Constant marginal utility leads to risk neutrality - Increasing marginal utility leads to risk seeking behaviour

A Fair Bet (Utility Function)

The utility derived from a lottery can be greater than the expected utility if risky prospects are not fair bets.

Certainty Equivalent and Risk Premium

The certainty equivalent is the amount of guaranteed income that an individual values equally to a risky income stream.
The risk premium is the difference between the expected value of a risky outcome and its certainty equivalent.

Attitudes to Risk (Again)

Risk-averse individuals require a risk premium to accept a risky investment.
Risk-neutral individuals have no risk premium required.
Risk-seeking individuals have risk premium reduced or negative.

Arrow-Pratt Measure of Risk Aversion

Risk aversion is determined by the curvature of the utility function. A risk averse individual receives less expected utility compared to a risk neutral individual or a risk-seeking individual..

Modelling Economic Decisions

Using expected utility theory facilitates the modelling of economic decisions in the presence of uncertainty.
Applying expected utility maximisation necessitates solving for the most optimal choices and considering first-order conditions.

Testing the Model -- Data

Testing economic models in the presence of uncertainty generally employs macroeconomic or microeconomic datasets.
Life cycle data can be used in the estimation process, for example, data on individuals at different ages, including crime aspects.
Macrodata is a commonly used approach and some research has supported the Becker Crime Model.

Extending the Model

The basic expected utility model can be expanded and applied to various types of crime and decisions beyond monetary gains and losses.
Some decisions might not involve ex ante/ex post consistency given the non-materialistic items that drive the outcome.

What About Wealth?

Wealth has no effect on probability, but it has an impact on the marginal utility of income which can be used to inform decision making.

Marginal Utility and Risk Aversion

Risk aversion is correlated with diminishing marginal utility.
A decision maker’s risk perception is influenced by their marginal utility, probability of success and other variables.

Basic Takeaways of Rational Choice Model

Reducing crime is usually about increasing punishments and/or increasing probability of being caught.
Reducing inequality can also impact crime rates, or have an equivalent effect to modifying the expected payoff for crime.

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Description

Explore key concepts in economic decision-making, including expected utility theory, labour supply corner solutions, and reservation wages. Understand how individuals maximize utility under uncertainty and the implications for labour choices in relation to wage expectations.