Risk and Utility in Decision Making
Risk Aversion
Definition: Risk averse individuals prefer to avoid uncertainty and potential losses even at the cost of lower potential gains.
Example: Given a choice to gain $20,000 with 50% probability or lose $20,000, a risk averse person will likely choose not to invest.
Cost-Benefit Analysis
Individuals perform an informal cost-benefit analysis based on outcomes and their probabilities.
Example: If investing has a 50% chance of gaining $30,000 or losing $10,000, the expected payoff can be calculated.
Calculation:
Expected Value = (0.5 * 30,000) + (0.5 * (-10,000)) = 15,000 - 5,000 = 10,000.
Utility Theory
Utility: Represents an individual's satisfaction or happiness derived from wealth or goods.
Diminishing Marginal Utility: As wealth increases, the incremental happiness from each additional dollar decreases.
Example: Utility from an initial wealth of $80,000 versus increments of wealth beyond that level.
Risk averse individuals exhibit flatter utility curves, indicating less satisfaction from additional wealth.
Different Degrees of Risk Aversion
Individuals exhibit varying levels of risk aversion; what might seem like an acceptable risk to one person could be unacceptable to another.
Example: Some may choose to take a new job with double the salary and a chance of income reduction, while others remain conservative.
Subjective Preference and Decision Making
Individuals base their decisions on risk based on their current financial situations and life circumstances.
Example: If $10,000 is a significant hit for someone, they would not accept risky investments even with high potential returns.
Expected Utility
To quantify decision-making under risk, utility can be assigned to different outcomes and their probabilities calculated.
Example: If current wealth is $30,000, evaluate the utility of investing that could either lead to $50,000 with 40% probability or a loss resulting in $15,000 with 60% probability.
Utility Ratings: Assign utility scores using a 0-10 scale based on wealth scenarios.
Risk Intelligence
Definition: The ability to make well-informed decisions regarding risk based on available information and willingness to adapt beliefs.
Differences among people in risk evaluation and the importance of self-awareness and information processing in risk taking.
Example: Professional gamblers often excel at assessing odds not just through chance but through detailed understanding and calculation.
Strategies for Assessing Risk
Successful risk takers maintain accurate records of their decisions to recognize errors and adapt strategies.
Gathering information expands the decision-making horizon and improves outcomes.
Expertise in a domain can enhance risk assessment abilities; being educated about specific situations leads to better informed decisions.
Conclusion
Evaluating risk involves balancing the potential gains against the possible losses.
Understanding how personal circumstances affect perceptions of risk can help in making more rational economic decisions.