Contents
What is wrong with expected utility theory?
Expected utility theory makes faulty predictions about people’s decisions in many real-life choice situations (see Kahneman & Tversky 1982); however, this does not settle whether people should make decisions on the basis of expected utility considerations.
What does the Ellsberg paradox violate?
Ellsberg’s findings violate assumptions made within common Expected Utility Theory, with participants strictly preferring Gamble A to Gamble B and Gamble D to Gamble C.
What are the assumptions of expected utility theory?
There are four axioms of the expected utility theory that define a rational decision maker: completeness; transitivity; independence of irrelevant alternatives; and continuity. Completeness assumes that an individual has well defined preferences and can always decide between any two alternatives. or both.
Can prospect theory explain the Ellsberg paradox?
Next, a behavioral model based on our “Prospect Theory under Uncertainty” is described where basic probability of a set of events is known but occurrence probability of each event is not known. It is shown that this model could properly explain the Ellsberg paradox of ambiguity aversion.
What is an expected utility Maximiser?
An expected utility maximiser is a theoretical agent who considers its actions, computes their consequences and then rates them according to a utility function. Next, it performs the action which it thinks is likely to produce the largest utility.
What does expected utility theory say?
The expected utility of an entity is derived from the expected utility hypothesis. This hypothesis states that under uncertainty, the weighted average of all possible levels of utility will best represent the utility at any given point in time.
What are the predictions of subjective expected utility theory?
According to the subjective expected utility theory, individuals are more likely to select an option that maximize (minimize) the positive (negative) outcomes of their response (Shanteau & Pingenot, 2009) .
What is financial prospect theory?
The prospect theory says that investors value gains and losses differently, placing more weight on perceived gains versus perceived losses. An investor presented with a choice, both equal, will choose the one presented in terms of potential gains.
Is a paradox true?
A paradox is a logically self-contradictory statement or a statement that runs contrary to one’s expectation. It is a statement that, despite apparently valid reasoning from true premises, leads to a seemingly self-contradictory or a logically unacceptable conclusion.
What is loss aversion in psychology?
Loss aversion in behavioral economics refers to a phenomenon where a real or potential loss is perceived by individuals as psychologically or emotionally more severe than an equivalent gain. For instance, the pain of losing $100 is often far greater than the joy gained in finding the same amount.
What is independence axiom?
The independence axiom postulates that decision maker’s preferences between two lotteries are not affected by mixing both lotteries with the same third lottery (in identical proportions).
What is invariance axiom?
In addition to conventional smoothness and proportionality conditions, in each case an Invariance Axiom is proposed. For technological change this says, in a sense, that when there is no technological change there is no change in the index.
What is independence in expected utility theory?
The independence axiom states that this indifference should be independent of context. That is if you put A and B inside another lottery you are still indifferent.
Which of the following axioms does the Allais paradox violate?
Abstract. The so-called Allais Paradox (Allais (1953)) has been interpreted as a violation of the independence axiom of Savage (1954). Considering the standard experiments performed this inference is questionable. Rather the paradoxical behavior represents evidence against the expected utility hypothesis as a whole.
How does prospect theory explain the Allais Paradox?
Prospect Theory: A form of decision theory that suggests people perceive value in relation to gains and losses rather than in absolute terms. Derived from experimental results, it assumes that the prospect of a loss looms larger than that of a gain.
What is common consequence effect?
A common consequence effect (CCE) occurs if the preference between two lotteries changes if the same probability mass is shifted from one common outcome to a different common outcome in both lotteries.
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