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Its EV is?
1. $0; 2. $50; 3. 100; 4; $200
To bet or not to bet*
A $200 wager on next card and
win quadruple ($800) on
Heart
lose bet on others.
Its EV is
(0.25)(800)+(0.75)(-200)=50
Risk attitude
Willing or not entering a fair gamble depends on
risk attitude
50
%
5% 10% 15% 20%
Expected Utility Theory
+% 0 5 8 10 12 15 20
u(+%) 0 8 16 19 26 46 100
1. +8% (50%) or +12% (50%);
2. +5% (50%) or +15% (50%);
3. +0% (50%) or +20% (50%);
Which option will this agent prefer?
Expected Utility Theory
+% 0 5 8 10 12 15 20
u(+%) 0 8 16 19 26 46 100
(); EU
() whos
100 risk loving
50
27
21
%
5% 10% 15% 20%
Prospect theory
Reference dependent
= ((1 ))(1) +
() ((2 ))(2) +
() is asymmetric. (loss
aversion)
() is distorted, usually
overestimates when p is very
small and underestimates
when p is very large.
Framing effect of the
reference point.
Loss aversion
While being averse
to possible gains,
individuals tend to
be risk-loving while
facing chances to
recover possible
losses.
Twice sensitive to
loss than to gain
Nonlinear probability weighting
(subjective prob.)
: the =
1
subjective weighting
function, of objective
Inverted S-shaped
probabilities of
possible outcomes, ()
( ).
Inverted S-shape
() > for very small
; over-estimate S-shaped
now now
later later
The Marshmallow Test
The Marshmallow Test
Choice between
1 marshmallow now
2 marshmallows later
now now
As long as monkeys
give discounts (say
later 0.5) to future rewards, later
they will prefer
starting a diet (*)
start start
a diet a diet
today tomorrow
Starting tomorrow:
Benefit is to be able to eat what you want for
another day
Cost is delaying becoming healthier
Problem:
One-third of long-
term smokers die
prematurely.
So what?
$100 $105
now next year
$100 $105
10 years 11 years
from now from now
Preference reversal
Distinct choices at
different reference
points.
Do people exhibit a
preference for immediate
gratification?
2015 Pearson Education, Ltd.
http://waitbutwhy.com/