Shafir&Tversky - Shafir & Tversky Chapter...

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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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Shafir&Tversky - Shafir & Tversky Chapter...

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