Decision Making & Risky Choice

Deterministic

A decision which has a certain outcome

Probabilistic

A decision which has several possible outcomes

What is decision making according to Lee (2014)?

“Decision making is an abstract term referring to the process of selecting a particular option among a set of alternatives expected to produce different outcomes. It can be used to describe an extremely broad range of behaviours”

What are value-based decisions?

Decisions based on subjective value - can reveal personal preferences. Choices typically involve risk/ uncertainty about outcomes.

What is the risky choice paradigm?

It is the dominant approach to studying valuation and the way this is influenced by risk/ uncertainty about outcomes

How do you calculated expected value of an outcome?

1. multiply each value of outcome by probability of outcome

2. sum this

e.g. (0.5 x £50) + (0.5 x £0) = £25

so, expected value of obtaining £50 with a probability of 0.5 is £25

What is risk?

When outcomes are probabilistic but we know the probabilities (e.g. - coin flip)

What is uncertainty?

When outcomes are probabilistic but we don’t know the probabilities (or we may only be able to estimate them with some degree of… uncertainty)

Why is looking at expected value (EV) only not representative of reality?

People tend to be risk averse so will pick a ‘for sure’ option even if the EV is less

What did Daniel Bernoulli (1738) say about value?

“the determination of the value of an item must not be based on its price but rather the utility it yields… the utility is dependent on the particular circumstances of the person making the estimate”

What is the concept of Utility?

It is non-linear (concave) function of value - double the value might not equal double the utility - tends to level off

“psychoeconomic” function: translates objective value into subjective/ psychological value - internal dimension so doesn’t really have a measurement

e.g. - the same additional amount of money is worth less the richer you are

How do you calculate expected utility?

1. multiply the utility of each possible outcome by its probability

2. sum the products

What would a utility curve look like for a risk seeking individual?

It would accelerate

Why might utility curves vary?

individual factors (e.g. risk aversion/seeking), context, goods, cultures

Why is Expected Utility Theory useful?

1. The concept of utility - a translation of real world value into a subjective value

2. Provides an elegant explanation of risk aversion

3. Used as a base for a lot of economic theory

4. Lays the basis for one of the most influential psych theories of risky choice → Prospect theory

Why should Expected Utility not be taken too seriously?

1. It is often violated by actual human choice

2. It is not a psychological theory but an economic theory