Expected Value and Utility Theory

These flashcards cover the key concepts of Expected Value and Utility Theory discussed in the lecture.

Who developed the Expected Value and Utility Theory in the 1940s?

John von Neumann and Arthur Morgenstern.

What is the focus of Utility Theory when making decisions?

People make decisions based on the expected utility (value of outcome) rather than the possible outcomes.

What is a key application of Utility Theory in investment behavior?

Understanding the risk versus reward relationship.

According to Utility Theory, why might a risk averse person purchase insurance?

They believe the utility of avoiding loss outweighs the expected cost of the insurance.

How does John Stuart Mill's philosophy relate to Utility Theory?

Mill appreciated Expected Value Utility Theory as it aligns with his utilitarian philosophy that emphasizes maximizing utility.

What is the basic equation for Expected Value?

E(x) = PWin * Win$ - PLose * Lose$.

What types of individuals are classified in relation to risk in Utility Theory?

Risk Seeking, Risk Neutral, and Risk Averse.

Describe a Risk Seeking individual in terms of profit and gamble.

They value a larger profit at a lower chance of obtaining it and are willing to gamble.

What characterizes a Risk Neutral individual?

They value a safe and consistent profit and opt for a 1:1 profit to gamble ratio.

Define a Risk Averse individual.

They prefer a lower, guaranteed profit for a higher chance of obtaining it.