Chapter 6-Rational choice
under risk and uncertainty
A Course in Behavioral Economics by Erik Angner
Instructor: Tolga Yuret
Introduction
• you face a choice under uncertainty when the probabilities of the
relevant outcomes are completely unknown or not even meaningful;
• you face a choice under risk when the probabilities of the relevant
outcomes are both meaningful and known.
Uncertainty
• Imagine that you are about to leave your house and have to decide
whether to take an umbrella or to leave it at home.
• If you do not take the umbrella and it does not rain, you will spend
the day dry and happy; if you do not take the umbrella and it does
rain, however, you will be wet and miserable
• If you take the umbrella, you will be dry no matter, but carrying the
cumbersome umbrella will infringe on your happiness.
Umbrella problem
• {Rain, No Rain} are states of the world.
• {Take umbrella, Do not take umbrella} are decision maker’s options.
Maximin Criterion
• According to the maximin criterion, you should choose the
alternative that has the greatest minimum utility payoff.
• If you take the umbrella, the minimum payoff is three; if you leave the
umbrella at home, the minimum payoff is zero. Consequently,
maximin reasoning would favor taking the umbrella.
Maximax criterion
• According to the maximax criterion, you should choose the
alternative that has the greatest maximum utility payoff. If you take
the umbrella, the maximum payoff is three; if you leave the umbrella
at home, the maximum payoff is five.
• Thus, maximax reasoning would favor leaving the umbrella at home.
• The maximin reasoner is as cautious as the maximax reasoner is
reckless.
Minimax-Risk criterion
• According to the minimax-risk criterion, you should choose the alternative
that is associated with the lowest maximum risk or regret.
• If you take the umbrella and it rains, or if you leave the umbrella at home
and it does not rain, you have zero regrets. If you take the umbrella and it
does not rain, your regret equals the best payoff you could have had if you
had acted differently (five) minus your actual payoff (three), that is, two.
(see next slide )
• If you leave the umbrella at home and it does rain, your regret equals
three.
• Since bringing the umbrella is associated with the lowest maximum regret
(two, as opposed to three), minimax-risk reasoning favors taking the
umbrella.
• Homework: Do exercise 6.2
Rawls
• Of all criteria for choice under uncertainty, the maximin criterion is the
most prominent. It is, among other things, an important part of the
philosopher John Rawls’s theory of justice.
• Find ourselves behind a “veil of ignorance,” meaning that we were
deprived of all morally relevant information about themselves, the society
in which they live, and their place in that society.
• Live either in a society with masters and slaves or in a more egalitarian
society, without knowing whether you would be master or slave.
• According to Rawls, the rational procedure is to rank societies in
accordance with the worst possible outcome (for you) in each society –
that is, to apply the maximin criterion – and to choose the more egalitarian
option.
Maximin critisism
• maximin reasoning fails to consider relevant utility information, since
for each act, it ignores all payoffs except the worst.
Maximin critisism
• Another objection is that maximin reasoning fails to take into account
the chances that the various states of the world will obtain.
• Harsyani Challenge: Suppose you live in New York City and are offered
two jobs at the same time. One is a tedious and badly paid job in New
York City itself, while the other is a very interesting and well-paid job
in Chicago.
• But the catch is that, if you wanted the Chicago job, you would have
to take a plane from New York to Chicago (for example, because this
job would have to be taken up the very next day). Therefore, there
would be a very small but positive probability that you might be killed
in a plane accident.
Maximin critisism
• Harsanyi points out, maximin reasoning would favor the tedious NYC
job, no matter how much you prefer the Chicago job and no matter
how unlikely you think a plane accident might be. This does not
sound quite right.
Expected Value
• The expected value of a gamble is what you can expect to win on the
average in the long run, when you play the gamble.
• Suppose I make you the following offer: I will flip a fair coin, and I will
give you $10 if the coin comes up heads (H), and nothing if the coin
comes up tails (T). This is a reasonably good deal: with 50 percent
probability you will become $10 richer.
• It is clear that on the average, in the long run, you would get $5 when
playing this gamble; in other words, the expected value of the gamble
is $5.
• Homework: Do exercises 6.5, 6.6, and 6.7
More than one gamble
• For the following questions, refer to Figure 6.3(c).
(a) What is the expected value of accepting this gamble?
(b) What is the expected value of rejecting it?
Expected Value
Deal or no deal
You are facing three boxes. One of them contains $900,000, one contains
$300,000, and one contains $60, but you do not know which is which. Here
are the rules: if you choose to open the boxes, you can open them in any
order you like, but you can keep the amount contained in the last box only.
(a) What is the expected value of opening the three boxes?
(b) The host gives you the choice between a sure $400,000 and the right to
open the three boxes. Assuming you want to maximize expected value,
which should you choose?
(c) You decline the $400,000 and open a box. Unfortunately, it contains the
$900,000. What is the expected value of opening the remaining two boxes?
Homework: Do exercises 6.11, 6.12, 6.13, 6.15, 6.16, and 6.19
St Petersburg paradox
• A gamble is resolved by tossing an unbiased coin as many times as
necessary to obtain heads. If it takes only one toss, the payoff is $2; if
it takes two tosses, it is $4; if it takes three, it is $8; and so forth
• What is the expected value of the gamble?
This means that if you try to maximize expected value, you should be willing to
pay any (finite) price for this gamble. That does not seem right.
Expected Utility
• a dollar is not as valuable as every other dollar. You may care more
about a dollar bill if it is the first in your pocket than if it is the tenth.
• that is utility for money is concave.
• this will solve the St. Petersburg paradox.
Expected Utility
Homework: Do problems 6.23, 6.24, 6.25, 6.26, 6.30 and 6.31
Attitudes Towards Risk
• Suppose you own $2 and are offered a gamble giving you a 50
percent chance of winning a dollar and a 50 percent chance of losing
a dollar.
• Utility function is u(x)= 𝑥 , so that marginal utility is diminishing.
Should you take the gamble?
• No, since:
• EU(Accept)= ½ 3 + ½ 1 = 1.37
• EU(Reject)= ½ 2 + ½ 2 = 1.41
Attitudes towards risk
• Now suppose that your utility function is u (x) = x2.
• EU(Accept)=4.5+0.5=5
• EU(Reject)=2+2=4
• Risk prone (or risk loving)
• In general: Linear demand: risk neutral, Convex: Risk prone, Concave: Risk
Averse
Same person may have different risk attitudes
Certainty Equivalent
• The certainty equivalent of a gamble G is the number CE that satisfies
this equation: u (CE) = EU (G).
• If risk averse CE<EV(G)
• If risk prone CE>EV(G)
• We learned that for an agent with utility function u(x) = log(x), the
expected utility of the St Petersburg gamble is approximately 0.602.
What is the certainty equivalent of the gamble?
• We compute the certainty equivalent by solving the following
equation:
• log(CE) = 0.602. Thus, the certainty equivalent CE = 100.602 = 4.00.
That is, the St Petersburg gamble is worth $4.
• Homework: Do exercises 6.34, 6.36, 6.38, 6.40 and 6.44
Discussion
• Sometimes decision theorists use the term “right” to denote the decisions
that lead to the best possible outcome. The fact that good decisions can
have bad outcomes means that decisions can be rational but wrong.
• They can also be irrational but right, as when you do something completely
reckless but see good results anyway; buying a lottery ticket as a means to
get rich and winning truckloads of money might fall in this category. It goes
without saying that we always want to make the right decision.
• The problem, of course, is that we do not know ahead of time which
decision is the right one. That is why we aim for the rational decision –
being the one with the greatest expectation of future utility.
Discussion
• Philosopher L. A. Paul, for example, has argued that it is impossible to
make a rational decision about having a child, because you cannot
know ahead of time what it will be like, for you, to have a child. But
such arguments may confuse the rational with the right. It is true that
you cannot know what the right decision is: you may be very happy
with a child, or you may be miserable. But you never know ahead of
time what the right decision is.