Shafir & Tversky Chapter
1.Explain expected value theory.
Choice between a risky prospect and an alternative that are equivalent
most people prefer the sure
gain over the gamble, although they have the same expected value. The expected value of a gamble is a
weighted average where each possible outcome is weighted by its probability of occurrence.
Risk Averse
= preference for a sure outcome over a risky prospect that has higher or equal expected value;
Risk Seeking=
preference for a risky prospect over a sure outcome that has higher or equal expected value.
People tend to be risk averse when choosing between prospects with positive outcomes.
2.Explain expected utility theory.
Risk aversion is explained by the notion of diminishing sensitivity. I.e. $100 has a greater impact when
being added to $100 than to $800. Utility is a function of money
utility differences vary throughout the
function, but the dollar differences remain the same.
3.What is the shape of expected utility function for gains? For losses?
The concave function captures a person’s subjective value for money. i.e. subjective value attached to a
gain of $100 is more than the possibility of gaining $200 which explains preference for the sure $100
gain
Risk Aversion. This is a concave function. In terms of losses, people reject the sure loss of $100 ad
prefer to take an even chance at losing $200 or nothing (still, same expected
value)
Risk Seeking. The subjective value function for losses is convex.
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 Fall '10
 Shultz
 Utility, risky prospect, subjective value

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