6 Questions
What is the expected value of the lottery (𝐿) in the EU framework?
60
In the EU framework, what is the decision maker's risk attitude?
Risk seeking
What is the weight attached to the outcome 100 in the Rank Dependent utility framework?
0.25
What is the implication of the certainty equivalent being lower than the expected value in the RDU framework?
The decision maker is risk averse
What is the main difference between the EU and RDU frameworks?
The way probabilities are weighted
What is the main insight from the example?
The utility function is not the only way to capture risk preferences
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
This quiz assesses your understanding of expected utility and risk preferences, including calculating certainty equivalents and identifying risk-seeking behavior. It also covers rank-dependent utility and the weighting of outcomes. Test your knowledge of these important concepts in microeconomics.
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