Imagine you are given a choice between two options

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: ay in which he noted a widespread preference for risk aversion. In an often referred to article in Scientific 87 American in the 1980s Daniel Kahneman and Amos Tversky gave a simple example of risk aversion (Kahneman and Tversky, 1982). Imagine you are given a choice between two options. The first is a sure gain of $80, the second a more risky project in which there is an 85% chance of winning $100 and a 15% chance of winning nothing. With the certain outcome you are assured of $80. With the riskier option your EMV would be $85 ($100*0.85 plus $0*0.15). Most people, say Kahneman and Tversky, prefer the certain gain to the gamble, despite the fact that the gamble has a higher EMV than the certain outcome (Bailey et al., in press). In 1944, von Neumannn and Morgenstern expanded preference theory and proposed that the fundamental logic of rational decision-making could be described by eight axioms that are paraphrased in the following statement: “Decision-makers are generally risk averse and dislike incurring a loss of $X to a greater degree than they enjoy making a profit of $X. As a result, they will tend to accept a greater risk to avoid a loss than to make a gain of the same amount. They also derive greater pleasure from an increase in profit from $X to $X+1 than they would from $10X to $10X+1 ” (Bailey et al., in press) They went on to show that if a decision-maker had a value system which was described by these axioms, then there existed a function, or curve, which completely described his attitude and feelings about money (Newendorp, 1996 p152). This curve is known as a preference, or utility curve. An example of a preference curve is shown in figure 5.5. Pleasure Increasing preference or desirability Increasing amounts of money (or some other criterion) Pain 88 Figure 5.5: A preference curve (source: adapted from Newendorp, 1996 p147) According to risk consultant Peter Rose (1987), a preference curve shows two things: • The pleasure (utility) associated with winning is generally less than the displeasure of losing the same amount (that is, it hurts more to lose than it feels good to win.) People will take a greater chance to avoid a loss than to make a gain of the same amount. • People feel more pleasure about gaining $10 going from, say, $10 to $20, than they do about gaining $10 going from $1500 to $1510. Theoretically at least it is possible to draw just such a curve for any individual. Different shaped curves would denote different types of decision-maker. The shape of the curve in the lower left-hand quadrant describes how the individual feels about loss and the one in the upper right quadrant is the individual’s attitude to risk and the levels of profit associated with risk. Many writers have categorised decision-makers according to the shape of their preference curves. In general, these authors perceive there to be three types of decision-maker: risk averters, average players (who would always choose the decision alternative with the maximum EMV) and risk-seekers. Each, they believe, has a distinctive preference curve. These curves are shown in figure 5.6. As indicated above, exten...
View Full Document

Ask a homework question - tutors are online