An analysis of decision under risk

Exercise

After Russ Berrie & Co., USA acquired the company that made Koosh Ball, it was Jack Smith s job to improve sales and profit. The balls were made in Asia so he began by flying to Hong Kong and meeting with the manufacturer. But before the meeting, he contacted another firm in Asia to get a competitive price. They offered to make the balls for 3 cents less per ball. Smith now knew there was room for cost cutting with his primary manufacturer. In China, your word really matters and the honor you give your partner means everything.

Utility
Utility functions give us a way to measure investor's preferences for wealth and the amount of risk they are willing to undertake in the hope of attaining greater wealth. A utility function measures an investor's relative preference for different levels of total wealth

The non-satiation property states that utility increases with wealth, i.e., that more wealth is preferred to less wealth, and that the investor is never satiated { he never has so much wealth that getting more would not be at least a little bit desirable).

 The marginal utility of wealth decreases as wealth increases. Consider the extra (marginal) utility obtained by the acquisition of one additional dollar. For someone who only has one dollar to start with, obtaining one more dollar is quite important. For someone who already has a million dollars, obtaining one more dollar is nearly meaningless. In general, the increase in utility caused by the acquisition of an additional dollar decreases as wealth increases.

Decision making under risk can be viewed as a choice between prospects or gambles. A prospect (x1, p1; . .. ;xn, pn,) is a contract that yields outcome xi with probability pi, where p1 +p2+ . . .+pn, = 1.

Expected Utility Theory (EUT)

Decision maker (DM) chooses between risky or uncertain prospects by comparing Their expected utility values, i.e., the weighted sums obtained by adding the utility values of outcomes multiplied by their respective probabilities Expectation: U(x1, p1 ~. ;. . ;xn, pn) =p1u(x1)+ . . . +pnu(xn). Where U is the overall utility of a prospect

 EXPECTED UTILITY THEORY has dominated the analysis of decision making under risk. It is assumed that all reasonable people would wish to obey the axioms of the theory, and that most people actually do, most of the time.

Utility

Probabilities

Prospect Theory
There are several classes of choice problems in which preferences systematically violate the axioms of expected utility theory.

Certainty, Probability & Possibility

PROBLEM1: Choose between
A: 2,500 with probability 0.33 2,400 with probability 0.66 0 with probability 0.01 OR B: 2,400 with certainty

Results N =72

A [18]

B [82]*

In Expected Utility Theory, the utilities of the outcomes are weighted by their probabilities

CERTAINTY EFFECT
People s preference systematically violate principle of Expected Utility Theory Tendency to overweight outcomes that are considered certain, relative to outcomes which are merely probable

PROBLEM2: Choose between

C: 2,500 with probability .33, 0 with probability .67; OR D: 2,400 with probability .34, 0 with probability .66

Results D [17] N=72 C [83]* Problem 2 is obtained from Problem 1 by eliminating 0.66 chance of winning 2400 from both prospects under consideration. The change produces greater reduction in the desirability when it alters the character of the prospect from a sure gain to a probable one, than when both the original and the reduced prospects are uncertain

PROBLEM 3 A: (4000, 0.80) PROBLEM 4 C: (4000, 0.20) 0.25) or D : (3000, or B: (3000)

Results N =95 N=95 Problem 3 A [20] Problem 4 C [65]* B[80]* D [35]

The substitution axiom of utility theory asserts that if M is preferred over N, then any (probability) mixture (M, p) must be preferred to the mixture (N,p). Thus, reduction of probability winning from 1.0 to 0.25 has greater effect than the reduction from 0.8 to 0.2.

PROBLEM 5 A : 50% chance to win a 3 week tour to England, France and Italy or B : A 1 week tour of England with certainty

 N =72

A[22]

B[78]*

PROBLEM 6 C : 5% chance to win a three week tour of England, France & Italy OR D : 10% chance to win a 1 week tour of England

N=72

C [67]*

D[33]

PROBLEM 7 A : (6000, 0.45) PROBLEM 8 C : (6000, 0.001) C : (3000, 0.02) B : (3000, 0.90)

RESULTS Problem 7 N=66 Problem 8 N=66 Conclusion Where winning is possible but not probable (very minuscule 0.001 & 0.002) , most people choose the prospect that offers the larger gain. A[14] C [73]* B[86]* D [27]

REFLECTION EFFECT
What happens when gains are replaced by losses PROBLEM 8 A : (-4000, 0.80) C : (-3000,0.90) B : (-3000) D : (-6000, 0.45)

RESULTS Problem 8 N=95 N=66 A [92]* C[8] B[8] D [92]*

Preference between negative prospects is the mirror image of preference between positive prospects. Thus, the reflection of prospects around 0 reverses the preference order. Thus, reflection effect implies that risk aversion in the positive domain is accompanied by risk seeking in the negative domain

Framing Effect Example 1

Problem 1 (Survival frame) Surgery: Of 100 people having surgery 90 live through the post- operative period, 68 are alive at the end of the first year and 34 are alive at the end of five years. Radiation Therapy: Of 100 people having radiation therapy all live through the treatment, 77 are alive at the end of one year and 22 are alive at the end of five years

 Problem 1 (Mortality frame) Surgery: Of 100 people having surgery 10 die during surgery or the post-operative period, 32 die by the end of the first year and 66 die by the end of five years. Radiation Therapy: Of 100 people having radiation therapy, none die during treatment, 23 die by the end of one year and 78 die by the end of five years

Outcome
The inconsequential difference in formulation produced a marked effect. The overall percentage of respondents who favored radiation therapy rose from 18% in the survival frame (N = 247) to 44% in the mortality frame (N = 336). The advantage of radiation therapy over surgery evidently looms larger when stated as a reduction of the risk of immediate death from 10% to 0% rather than as an increase from 90% to 100% in the rate of survival. The framing effect was not smaller for experienced physicians or for statistically sophisticated business students than for a group of clinic patients

Framing
Framing, a term used in media studies, sociology and psychology, refers to the social construction of a social phenomenon by a mass media sources or specific political or social movements or organizations. It is an inevitable process of selective influence over the individual's perception of the meanings attributed to words or phrases. A frame defines the packaging of an element of rhetoric in such a way as to encourage certain interpretations and to discourage others.

Example
The initial response of the Bush Administration to the assault of September 11, 2011 was to frame the acts of terror as crime. This framing was replaced within hours by a war metaphor, yielding the War on Terror". The difference between these two framings is in the implied response. Crime connotes bringing criminals to justice, putting them on trial and sentencing them, whereas as war implies enemy territory, military action and war powers for government

What are chances of winning a major prize in instant scratchies ?

If we return to our prospect theory we see that framing of the offer becomes very important in low probability situations.

The people code the outcome of the lottery as a gain by ensuring that it is right outside of most peoples natural reference point (status quo).

 Thus, although is generally desirable, it appears that certainty increases aversiveness of losses as well as the desirability of gains

Prospect Theory
Major violations of Expected Utility theory Value function is concave for gains, Value function is convex for losses, Steeper for losses than for gains Nonlinear transformation of the probability scale, which overweights small probabilities and underweights moderate and high probabilities

 The journey continues

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