School of Politics, Economics and

International Relations

LECTURE 1 – DECISION UNDER RISK

Dr Steven Bosworth

EC301 Advanced Microeconomics – 25 September 2023

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THE PURPOSE OF THEORIES
• In general, we can see a theory as a simplified representation of reality;
as such, a theory ‘can never be right’, i.e. it will never capture all of
reality
• In first approximation, we would thus want a theory to capture some
essential aspects of a process we are interested in, while abstracting
from non-essential aspects
• Hal Varian, ‘What use is economic theory?’: Economics is like
engineering rather than physics, needs to be useful for policy.
1. theory substitutes data
2. helps identifying useful parameters to measure
3. can generate useful (non-obvious) insights
4. allows for quantification and calculation
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5. can be verified experimentally
DESCRIPTIVE ACCURACY
OF THEORIES
• While a theory can never be right, we would nonetheless like it to
capture the fundamental aspects of a situation
• A theory needs to be descriptively accurate for most important
phenomena it describes in order to be useful to policy
• Another way of thinking about this is its predictive accuracy (without
prediction no prescription)
• There exists a fundamental tension between predictive or descriptive
accuracy and parsimony; we would like simple theories that capture the
essentials
• Prediction of outcomes versus description of processes: revealed
preferences versus procedurally accurate theories
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TYPES OF THEORIES
• We distinguish between three fundamental types of theories:
1. Normative theories: these theories tell us how we should behave
to obtain a certain goal (usually utility maximisation)
2. Descriptive theories: how people do really behave, and may or
may not be the same as the normative theory
3. Prescriptive theories: how can people be induced to take better
decisions, usually based on the application of normative principles
(useful in highly complex contexts)
• We will mostly treat normative theories in EC301; these theories were
meant to be descriptive when originally introduced;
• We will see some examples why their descriptive validity is in many
instances questionable; more on this in EC343 Behavioural Economics
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EXPECTED UTILITY THEORY
• Individual decision making processes under risk are pervasive in
economics
• Example: an individual needs to decide between allocating her wealth;
she can pick bonds, stocks, or a real estate portfolio; how will/should
she decide?
• Even decisions involving other players (game theory), or by managers
of firms (oligopoly), all involve some of these aspects
• We start out by studying these problems in extremely simplified settings

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EXPECTED UTILITY THEORY
• We will study choices over very simple binary lotteries involving given
probabilities:
• These objects serve to focus on the essentials of a problem (much like
theory)
• They do, however, abstract from some important features of real
decisions:
1. Real objects are often much more complex, containing e.g. many
more possible outcomes and compound lottery structures
2. More often than not, probabilities are not objectively given in real
decisions: either past frequencies or subjective probabilities
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EXPECTED UTILITY THEORY

• These differences often matter! Limited cognitive resources, dislike of

ambiguity, systematic distortions in belief formation
• Ultimately, we want to understand real decision processes in financial
markets (e.g. the ‘equity premium puzzle’); when selling houses or
stocks etc.
• Game theory: decisions under uncertainty with beliefs informed by
common knowledge of perfect rationality

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BASIC SETUP AND NOTATION
• In general we will study risk, i.e. problems in which probabilities are
objectively known (roulette wheels)
• We will focus mostly on binary prospects (i.e. lotteries), with two
outcomes ; we can write this as
• Alternatively, choices will be represented using decision trees:

• We are then interested in preference relations between such prospects;

indicates indifference, weak preference, and strict preference
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EXPECTED VALUE
• Historically, the first theory used to model decision making under risk
was expected value theory; EVT ()
• Under EVT the value of a prospect is simply taken to be its
mathematical expectation:

• Is this a good theory of choice? Do you think it is descriptively valid?

• How about normativity? How does expected value theory accommodate
individual risk preferences?

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THE ST. PETERSBURG PARADOX
• Consider the following prospect. A fair coin is tossed. If it comes up
heads, you are paid £2. Then the coin is tossed again. If it comes up
heads again, you are paid £4; and so on. When the coin comes up tails,
you are paid the accumulated outcome (e.g. £ if tails comes up on the
third toss) and the game ends.
• If somebody offers you this prospect, how much would you be willing to
pay for the possibility to play it?
• How much is the expected value of this bet? Do your preferences
conform to expected value theory?
• Nobody’s preferences do! (although this example is quite artificial)
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THE ST. PETERSBURG PARADOX

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BERNOULLI’S SOLUTION
• Expected utility theory was first proposed as a solution to the St.
Petersburg paradox by Daniel Bernoulli in 1738
• The simple idea is that one’s WTP for that bet does not need to be
equal to infinity if one subjectively transforms outcomes
• In particular, the marginal utility of money is supposed to be decreasing,
so that after a certain wealth level any additional Pound will be worth
less in utility terms
• In mathematical terms, we can thus represent the utility of a prospect
as

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where the assumption is that and , i.e. utility increases in outcomes
(money), but at a decreasing rate.
BERNOULLI’S SOLUTION
• Bernoulli proposed that would solve the St. Petersburg paradox; (can
you show this? what is the EU? How much would you pay?)

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CERTAINTY EQUIVALENT
• We will measure the risk preferences of people; to do this, we will
generally need to elicit some kind of preference relation
• One convenient way is to find the sure amount of money that makes a
decision maker indifferent between playing the prospect and obtaining
that amount:

• We call this amount certainty equivalent (). The above relation can be
modelled as follows:
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EUT

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ASSUMPTIONS AND
THEIR CONSEQUENCES
• Several assumptions underlying EUT are often not spelled out in detail;
these assumptions will turn out to be crucial
• EUT is defined over final (lifetime) wealth states, that is, the outcomes
and depicted are wealth states, with outcomes potentially in the
millions of Pounds
• It is immaterial how the prospect obtains, i.e. whether it concerns i) a
gain starting from an initial point ; ii) a loss starting from an initial point ;
or iii) a mixed prospect from an initial point
• The concept of utility is meant to capture the decreasing marginal utility
of money, which in turn produces risk aversion over large stakes (see
e.g. Schoemaker, 1982)
• Probabilities are treated linearly. This for instance implies that implies ,
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AXIOMATIC FOUNDATIONS

• Axioms are behavioural principles that fully imply a theory, i.e. if

somebody obeys all the axioms she also obeys the theory
• Axioms are useful for many reasons, including intuitive tests of theory,
pinpointing violations, etc.

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AXIOMATIC FOUNDATIONS
EUT replies on four fundamental axioms:
1. Completeness: a DM can always decide, i.e. either or . (where ,
could be prospects)
2. Transitivity: a decision maker’s preferences are consistent; if and
then .
3. Continuity: if then such that .
4. Independence: An indifference between two prospects holds also if
both prospects are mixed with a common third prospect or outcome:
implies .
• For each one of the above ask yourself: would I want to obey this
axiom? Do most people likely obey it in practice?
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EXERCISE
• We will now do a typical exercise of the type you will encounter
throughout the course:
• A decision maker (DM) is asked to choose between different sure
amounts of money and a lottery (prospect). We observe that the DM is
indifferent between £7 for sure and a lottery giving a 10% chance to win
£100, or else nothing.
1. Write this preference down in terms of Expected Utility Theory
2. Can we say anything about the risk preference of the DM? Is she
risk averse or risk seeking? Can we quantify her preference?
3. Can we plot this decision maker's utility function?

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EXERCISE

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EXERCISE

• You should know how to solve this from EC201; if you cannot
remember, revise these materials
• I will post exercises for next week which are similar to this (plus some
more advanced materials)
• We will extend the EU model next week, and uncover some of its
shortcomings/complications

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CLASSROOM EXPERIMENT
• We will now conduct a classroom experiment. This experiment will try to
determine how you make decisions under uncertainty.
• We will use the answers in a bit, so we will be able to study how we
make decisions
• In this simple experiment we’ll ask you to fill in two MS Forms
questionnaires. You will find a link to each survey in your
@student.reading.ac.uk account.
• No need to discuss with classmates (no wrong answer just your
judgement!)
• if you have a question, raise your hand

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CLASSROOM EXPERIMENT
Survey 1: Choice tasks

Each question on the first survey will

involve two bets. If a bet is played, then a
20-sided die will be rolled (the faces of the
die are numbered 1, 2, …, 20). Depending
on the nature of the bet, the number drawn
will determine whether you win or lose an
amount of money. Bets will be indicated by
the figures onscreen. For example, if you
play the following bet, then you will lose £1
if the number shown on the die is less than
or equal to 7, and you will win £8 if the
number drawn is greater than 7.
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CLASSROOM EXPERIMENT
Survey 1: Choice tasks

You will be paid in the following fashion. Everyone will make a number of
decisions today on both Survey 1 and Survey 2. Later* I will draw one student ID
from the dataset at random and ask if you would like to have one of your bets
played (you may decline and I will select another). Only one of the bets you
choose will be carried out, chosen randomly. A coin will be tossed to determine
whether a bet from surveys 1 or 2 will be selected, and then a 10-sided die will be
thrown to determine which of the bets from the chosen survey is played. You will
be paid an amount depending on your decisions and upon the outcomes of the
bets in the chosen item – any amount you win will be paid out by me in cash, and
any amount you lose will be owed to me. However, the most you can lose on a
bet is £2, and I’m very forgiving :)

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You may now start the survey, choosing your preferred bets from the five pairs.
CLASSROOM EXPERIMENT
Survey 2: Pricing tasks

For each of the questions on Survey 2, imagine that you have been presented a
ticket that allows you to play a bet. You will then be asked for the smallest price at
which you would sell the ticket to the bet. If a question from this survey is chosen
at the end of the experiment, we will do the following. First, I will roll a 10-sided
die to determine a whole-£ amount offer. I will then throw two 10-sided dice (one
has a 10s digit) to determine the pence after the decimal. In this way I'll generate
an offer price between £0.00 and £9.99. If this offer price is greater than or equal
to the price you state is your minimum selling price for the item's bet, you would
receive the offer price. If the offer price is less than your selling price, you would
play the bet and be paid according to its outcome.

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CLASSROOM EXPERIMENT
Survey 2: Pricing tasks

It is in your best interest to be accurate; that is, the best thing you can do is to be
honest. If the price you state is too high or too low, then you are passing up
opportunities that you prefer. For example, suppose you would be willing to sell
the bet for £4 but instead you say that the lowest price you will sell it for is £6. If
the offer price drawn at random is between the two (for example £5) you would be
forced to play the bet even though you would rather have sold it for £5. Suppose
that you would sell it for £4 but not for less and that you state that you would sell it
for £2. If the offer price drawn at random is between the two (for example £3) you
would be forced to sell the bet even though at that price you would prefer to play
it. You may now start the second survey, stating your minimum selling price for
each of the 10 bets shown.

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FRIDAY

• Check Bb for problem set!

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