slide3-risk-theory

slide3-risk-theory - Risk Theory Professor Erkut Ozbay...

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Risk Theory Professor Erkut Ozbay Economics 300
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Is expected value a good criterion to decide between lotteries? One criterion to choose between two lotteries is to choose the one with a higher expected value Does this criterion provide reasonable predictions? Let’s examine a case… Lottery A: Get $3125 for sure (i.e. expected value= $3125) Lottery B: win $4000 with probability 0.75, and win $500 with probability 0.25 (i.e. expected value also $3125) Which do you prefer?
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Is expected value a good criterion to decide between lotteries? Probably most people will choose Lottery A because they dislike risk (risk averse) However, according to the expected value criterion, both lotteries are equivalent. The expected value does not seem a good criterion for people that dislike risk If someone is indifferent between A and B it is because risk is not important for him (risk neutral)
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Expected utility : The standard criterion to choose among lotteries Individuals do not care directly about the monetary values of the prizes they care about the utility that the money provides U(x) denotes the utility function for money We will always assume that individuals prefer more money than less money, so: '( ) 0 i U x
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slide3-risk-theory - Risk Theory Professor Erkut Ozbay...

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