Week 4: Decision making under risk and uncertainty

In the lecture this week we looked at the Utility theory, which is to do with the amount of wealth one has and the amount of risk willing to take to attain more wealth.


We discussed the three failures of the utility theory:

1. Risk-seeking versus risk-averse behaiour. Kahneman and Tversky (1992) researched risk attitudes, with regards to whether the outcomes are gains or losses, and whether probabilities are small or medium-to-large. they presented several problems for people to choose from, one half of the options are more risky, where as the other is risk averse; a sure loss. They show that the assumption that people are more liekly to undertake risk aversion behaiour is not supported, because they found that more people chose the risky options, making them more risk-seeking.

2. People do not maximise expected utility. People do not always choose decision options that will maximise expected utility. Allais (1953, 1990) created situations with different outcomes for people to choose from to assess behaviour. He found that people chose the option that does not maximise expected utility because they switch from certainty to uncertainty in their choices for different problems, depending on the amount of risk there is in a problem, they chose the situation with less risk for the first oroblem, and chose the more risky situation in the second problem, so aren't consistent in their choices.

3. People do not integrate prospects with existing assets. Kahneman and Tversky looked at two problems which had two situations to chose from in each. When presented with the problems the participants did not integrate the two, so did not put their assets together and look at it as a whole. This means they are likely to not maximise their utiliy.