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Questions and Answers
What is the expected value of the lottery (𝐿) in the EU framework?
What is the expected value of the lottery (𝐿) in the EU framework?
- 60 (correct)
- 80
- 70
- 50
In the EU framework, what is the decision maker's risk attitude?
In the EU framework, what is the decision maker's risk attitude?
- Risk averse
- Risk seeking (correct)
- Risk neutral
- Uncertain
What is the weight attached to the outcome 100 in the Rank Dependent utility framework?
What is the weight attached to the outcome 100 in the Rank Dependent utility framework?
- 0.5
- 1
- 0.25 (correct)
- 0.75
What is the implication of the certainty equivalent being lower than the expected value in the RDU framework?
What is the implication of the certainty equivalent being lower than the expected value in the RDU framework?
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What is the main difference between the EU and RDU frameworks?
What is the main difference between the EU and RDU frameworks?
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What is the main insight from the example?
What is the main insight from the example?
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Study Notes
Expected Utility (EU)
- EU is calculated as 𝐸𝑉(𝐿) = 0.5 × 100 + 0.5 × 20 = 60
- Expected utility is 𝐸𝑈(𝐿) = 0.5 × 1002 + 0.5 × 202
- Certainty equivalent EU is 𝐸𝑈(𝑐𝑒) = 𝐸𝑈(𝐿) and 𝑐𝑒 = √0.5 × 1002 + 0.5 × 202 = 72.11
- Decision maker is risk seeking because 𝑐𝑒 > 𝐸𝑉
Rank Dependent Utility (RDU)
- RDU requires ranking outcomes from best to worst: 100 > 20
- Weights 𝜋(.) are: 𝜋(100) = 0.25 and 𝜋(20) = 0.75
- RDU is calculated as 𝑅𝐷𝑈(𝐿) = 𝜋(100) × 1002 + 𝜋(20) × 202
- Certainty equivalent RDU is 𝑅𝐷𝑈(𝑐𝑒) = 𝑅𝐷𝑈(𝐿) and 𝑐𝑒 = √0.25 × 1002 + 0.75 × 202 = 52.9
- Decision maker is risk averse because 𝑐𝑒 < 𝐸𝑉
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